Reading time: < 1 minute

1. U Chicago econ prof Raghuram Rajan on the future of capitalism

2. Mankiw on the growth in the monetary base and its relation to inflation fears

3. VCs are being pushed to later stage investing

4. Ways of reading

5. Jonathan Gruber on the “Cadillac Tax“

Reading time: 5 – 8 minutes

Talk about secondary markets for private company stock has been heating up recently but the thought has been around for quite some time.  In fact I, along with others, wrote about secondary markets for private company stock in 2007 and 2008 and I am certain that the argument goes much further back than 2007 since the idea is essentially low hanging fruit.

Why is talk about secondary markets heating up now?

It seems the secondary market idea, as expected, tends to come back every time startups (and venture investors) have very few exit possibilities.  As of late things have been looking very grim with regard to exits.

The public markets have been virtually shut down in terms of startup IPOs for some time now.  In fact, I saw some numbers (via the NVCA) the other day that showed how bad the IPO market has become.  There were roughly 86 VC backed IPOs in 2007, 6 (yes, that’s a single digit) in 2008 and 0 thus far in 2009 (goose egg).

OK, so what about M&A activity?  From 2004 to 2008 M&A activity has hovered around 350ish VC backed M&A exits per year or about 87 M&A exits per quarter.  Q1 of 2009 saw only 56.  You may think that that number isn’t too far off the average but when it comes to the average size of M&A exits over time the picture becomes clearer.

In 2007 the average M&A deal size was $177mm.  2008 saw a decline to $115.7.  2009, thus far, comes in at a whopping $49.6mm average M&A deal size for VC backed startups.  Ouch!

Where else can we (entrepreneurs and VCs) get liquidity?

That’s certainly a loaded question but one that needs to be taken seriously and addressed.  Why? Well, if liquidity events are rare then VCs won’t make many investments and, therefore, startups will become more rare and, thus, a vicious cycle ensues that severely impacts our economy (especially given that VC backed startups are a large job creation engine for this country).

This is how we get to the idea of secondary markets.  Secondary markets exist for many illiquid assets at this time.  In fact, secondary markets even exist for Venture Capital fund positions (i.e. LPs can sell of their VC investments in a secondary market).

I have to admit that I do find the idea of secondary markets for VC backed (and non-VC backed startups) intriguing but I am starting to see some issues with the whole concept.  That said, before I get into some of the issues I would like to chat quickly about a pain in the butt accounting rule that may actually help to enable secondary markets for private company stock to function.

FAS 157

A lot has been written about FAS 157 and how terrible the rule is. Even FASB didn’t like the first version of the rule they released.  That said what FAS 157 does, in part, is force VCs to value their investments each quarter.  Since this is a giant hassle (for reasons I may take a whole other post to describe – on second thought that would just be tortuous for you and I so I will skip that post) a lot of valuation firms have been springing up to help VCs and other funds (PE, hedge funds, etc.) value their investments.

As a by product of this rule lots of data is being generated on private companies and the valuations over time.  This data could potentially form the backbone of a secondary market for private company stock (i.e. these valuations could be likened to the analyst reports for public companies and the secondary market participants would then go ahead setting the price for the private company stock).

Wow, this sounds great! What could possibly be wrong with a secondary market for private companies?

This is, again, quite a question.  One of my big concerns about a secondary market for private companies was something I initially missed in my thinking about them.  The issue is this:

If private companies begin to be traded on a secondary market and, through FAS 157, are valued regularly, what stops private companies from focusing on the short term (i.e. short term value of the company, etc.) just like publicly traded companies do (to their detriment it seems)?

One thing that is great about startups is that by nature they take the long view.  Startups try to create long term value and they tend not to worry about short term valuations of their stock or short term revenue opportunities.

If a secondary market begins to take that long term thinking away by pushing companies to focus short term doesn’t a private company simply become a defacto public company albeit with less regulation imposed on it?  I think it may.

Some other issues that come up are equally large.  In the words of Fred Wilson:

I understand that there are issues with this development. It will be harder to strike options at low prices when the company’s stock has a price history. It will be harder to control who the shareholders are and it will be harder to keep employees motivated to stick around if they can cash out early. These are all problems companies usually don’t face until they go public. Now they will have to face them earlier.

The issue that is that heart of the couple Fred mentions is continuity.  One reason startups are able to take the long view is that they generally have a stable management team and a stable group of investors/board members. Part of the stability of startups lies in the fact that everyone is in it together for the long term so-to-speak since they can’t liquidate their positions easily. If founders, investors, board members and employees can suddenly liquidate their stock fairly easily what is left to keep them around?

If you can’t keep your people around then you need to bring in new people. Now you’ve lost time and continuity, which is bad enough but you are also going to have a hard time setting option strike prices at a rate that give the potential new employees good upside potential.

In my mind, there is enough to worry about in an early stage startup without having to worry about a lot of the things startups have to worry about only when they go public.  It seems that adding more issues to the mix will potentially decrease the success rate of startups.

In conclusion

Fred and others (VCs and entrepreneurs alike) are fans of the secondary market idea even though they see the issues that come about. Even I can’t say that I am not, at some level, a fan of the idea (we need something that allows for liquidity).  It just seems to me that these secondary markets need to be well thought out so we don’t lose the long term thinking and alignment of interests that are both big parts of the world of startups and necessary for continued innovation and economic growth.

Reading time: 2 – 3 minutes

Matt McCall and I had a conversation a few days back about Dan Primack’s post on new VC models (I wrote about Dan’s piece a little over a week ago for those that missed it). I focused on the fact that too much money has been pushed into venture capital during both my conversation with Matt and in my blog post and I do believe that it is a main issue.  However, it appears that the increasing amount of money going into VC funds has a couple of underlying causes (if not more).

1. LPs are trying to push more money into venture capital funds to get lower their unfunded obligations.
2. Venture capitalists are only too happy to take the extra cash to bump up their management fees (since exits and carried interest are hard to come by these days).

Unfortunately point number two is causing a big issue.

VCs nowadays, at least the ones who have raised successive ~$500mm – $800mm funds (i.e. large funds) every couple of years, are in a position where management fees are so high that they can potentially lead to salaries to the main partners in the $6mm – $8mm range (give or take).

This fact, combined with the fact that the IPO market is essentially closed (meaning it is harder to generate exits and, subsequently, carried interest), means that VCs are content raising a lot of cash and deploying it fast so they can cash in on their management fees.  Any good investments that create some carried interest are simply a bonus.

For venture capital to work, carried interest, the amount the partners take of successful deals, needs to be the main driver.  Once management fees get too high they can become a primary driver and, as mentioned above, this scenario becomes even more pronounced when the IPO market is lacking and exits are harder to come by.

Matt just wrote about a post about his thoughts on the VC compensation issue, which, given his many years of experience, has a lot more meat to it than this post.  It is a must read post so please check it out when you have a chance. (Matt also talks about the structure of Warren Buffett’s first fund, which is interesting to note especially in the context of VC compensation.)

Reading time: 5 – 8 minutes

Dan Primack of PE Hub passes along an idea on how to revolutionize venture capital in his latest post. The idea, given to him from an unnamed Boston based VC, centers around the partner as the core of the VC fund.  Partners have always been the core of a VC fund, right?  Right.  However, in this new model Primack suggests there aren’t really any partners to speak of.  Each “partner” would work on his or her own with his or her own pool of money provided by one (or perhaps more) LPs.

The analogy Primack uses to explain this new idea is that of a professional athlete.  VCs have been compared to professional athletes for a long time due to a number of similarities with both professions. In this case the similarity we’ll focus on is that VCs, like professional athletes, usually work in teams but are judged on their individual numbers.

The issue with teams both in sports and in the VC world is that the stars can get pulled down by poor team members.  So, the thought is, why can’t a star VC just go “one-on-one” and raise an evergreen fund  from one LP (or perhaps more) that only he or she will manage.  These star VCs can then sign contracts with their LPs  (3 – 5 years to start was what was suggested), take a salary of $1mm per year, get 15% of any carry and hire an assistant and an associate.

It is suggested that this new venture capital model would provide better returns for LPs if the star VCs remained stars and, even if those VCs dropped off, the LPs would lose less then they would have if they picked a losing fund with multiple team members.

Primack, of course, realizes there are some issues with this idea and lists them in his post.  Two of them caught my eye:

1. What about the fact that the partnership model encourages working together to figure out if the deals a firm is looking at are really the best deals? Partners, in theory, should be helpful in that they may have different points of view about a deal that the deal-leading partner didn’t think of, etc., etc.

Primack refutes this by saying that most modern partnerships operate within a quid pro quo of silence. i.e. Don’t knock my deal and I won’t knock yours.  I haven’t been involved in any funds other than DFJ Portage and we operate in a very collegial way and speak our minds freely. That said, I actually haven’t seen Primack’s argument in reality although I could see his argument being the case at larger funds.

2. Would LPs be able to pick the right individual VCs?

That’s a big question but if an LP is on top of the goings on of their VC funds they probably already know who the superstars in their funds are.

I think the bigger question really is: Would the superstars consistently perform?

I don’t have the data on this but I know my friends at Cambridge Associates do so perhaps they can carry out this proposed study for me (hint, hint).

My idea for a study is to look at data from as far back as one can until the present day and then use the data to figure out if superstars are consistent over a long period of time or if the superstars during one 5 – 10 period are the dogs of the next. My guess: they aren’t consistent over long periods of time.

I fixate on this particular issue for one main reason and that is the fact that even the biggest of the big name VC funds – the blue chips as it were – are inconsistent in their returns.  Some of a given firms’ funds are top quartile and others are bottom quartile and some are in between.

A number of the big guys have fund returns that look like a roller coaster and it makes me think that the superstars would not fare much better.

Another point along the same line of thinking is that the superstar VC may actually be a superstar due to his or her team.  This point is also highly correlated to the entrepreneurs VCs back in that the team (the entrepreneurs plus the folks they hire) is everything.  Entrepreneurs have to be great leaders but they also need to hire great teams around them if they intend on bringing their companies to the highest level. Venture capitalists may also need their teams to help the VCs perform at the highest level possible.

With all that said it seems to me that trying to move the industry as a whole to the individual model or the partnership model doesn’t make much sense.  What works will differ based on the individual.  Some folks work well alone, some with a team, and so on and so forth.  What we, as an industry, probably need to address is the following:

Too much money has been flowing into VC for a while now.

Because of this fact funds are too big to do what VC is supposed to do.  $100mm or less (maybe a little more in some cases) is probably a good size fund for true seed and early stage investing.  Venture capital just doesn’t scale well and perhaps we need to accept this as an industry.  This is an important point and one that still needs to be addressed.

I am continually thinking about how to improve venture capital because I think venture capital is vital to the creation of great companies and life improving technologies. It has become fashionable to argue otherwise and I am actually happy about that.  I relish the posts about the death of venture capital.  Why? Well, because I try to look at those posts as a challenge for us, the VCs, to do better.  We can always do better.

Perhaps this superstar VC idea isn’t the way to improve venture capital (although some folks could try the model as it may work for some) but I am sure that through all of the discourse we will have as an industry in the coming years we’ll figure out of a few things that will make venture capital better at doing what it is supposed to do: find and fund bright entrepreneurs and then help them to create the next generation of new technology companies that will move the human race forward (while also generating a great return for our LPs of course).

Reading time: 6 – 10 minutes

I have to admit that Umair Haque’s recent two part series of posts on venture capital really made me want to start writing on this blog again.  His posts, entitled “Asleep at the Wheel of Creative Destruction” and “Five Problems Venture Capitalists Should Have Solved (But Didn’t)” really got me thinking.  In the words of my friend and partner in TECH cocktail crime, Frank Gruber, Haque got me “fired up!”

At a high level Haque is calling for VCs to step up their game and push innovation forward rather than sitting back, like some have been, and making a lot of “me too” investments that, even if they play out, don’t really move the needle much for the world in terms of meaningful change, job creation, etc. Here, here! I am with him 100% on changing the world for the better.  That’s why a lot of us got into VC and entrepreneurship in the first place.

I agree with Haque on a number of the points in the “Asleep at the Wheel” piece.  It certainly seems that the VC industry is flooded with too much capital looking for homes that don’t exist (however, some places, the Midwest for example, don’t have nearly enough capital to fund the great entrepreneurs, ideas and technologies they have) and that, as Haque puts it, a culture of imitation, rather than innovation, has started to permeate venture capital.  I also agree that “transparency, disclosure and discussion” can help venture capital by allowing it to become more participative and open.

Haque closes “Asleep at the Wheel” with this statement:

Unfortunately, today’s venture investors are about as interested in reform as yesterday’s bankers were. So it just might take a venture crash – just like Wall St’s financial crash – to wake up the guys and gals asleep at the wheel of creative destruction.

Ouch!  He may be right about some folks but, as long time readers know, I have been a big fan of innovation in the VC business for some time now (and have written about some innovative ideas in detail) and there are many other forward thinking VCs that are interested in improving their business too.

That said, we need to figure out a way to innovate that can also provide great returns for our investors.  One of the main issues is that we hold illiquid investments for a relatively long period of time before we can either sell them or, hold on to your hats people, IPO them (haven’t seen one of those in a while).  Once we put money into a company the clock starts ticking and, when the investment is finally exited, that clock allows VCs and their investors to calculate the efficiency or quality of an investment, which comes in the form of an IRR or Internal Rate of Return.

The IRR allows different investments to be compared to each other directly to help asses if the VC investment was a good one as compraed to, say, putting money in an S&P 500 index fund (i.e. just because you received 5x your money, for example, doesn’t mean the investment was the best one you could have made – the time your money was locked up in that investment needs to factor in).  Here is an example:

Say you invest $1,000,000 in a startup right now and you get $10,000,000 back at some point.  Either way you look at it you got 10 times your money back.  A huge home run right?  Not necessarily.  Let’s take a look at your IRRs at different periods of elapsed time:

$10,000,000 returned at 5 years: IRR = 58%

$10,000,000 returned at 10 years: IRR = 26%

$10,000,000 returned at 15 years: IRR = 17%

$10,000,000 returned at 20 years: IRR = 12%

Interesting isn’t it.  You wouldn’t have done much better than the long term market return if you couldn’t exit your deal before 20 years of hold time.  That means, at 20 years, you and your investors didn’t get a great return especially considering that, generally, the startup you invested in was inherently more risky than the overall market and, therefore, should have had a far better return than the market to account for the excess risk you took (more risk needs to equal more return to make things work – see alpha).

This is why VCs have specific hold time targets (usually about 5 -7 years and sometimes less) and limit their funds’ life to 10 years (if you have to hold investments longer than that the IRRs, even at 10x your money, start to degrade and the folks investing in your VC fund become unhappy).

The folks that invest in venture capital funds (i.e. the big institutions) want returns that make it worth the risk they took and those returns are affected by investment hold time.  Some of the things that Haque suggests VCs should have fixed or innovated on and the markets we should have created don’t appear to have the profiles that would make for good investment where good equals what LPs want in terms of IRRs.  Therefore, even if VCs did dive into this harder-to-solve stuff they may have done a lot of good but the returns may not have been there and, thus, these VCs would not be able to raise a new fund and continue to innovate since their investors would have been unhappy.

Bottom line: if the VC business wants to start moving in the direction of some of the issues Haque puts forth and suggests VCs should have solved than VCs need to figure out how to get the returns their investors demand while pushing forward on harder to solve problems.

At the end of the day venture capital still needs to be sustainable and that means driving good returns to LPs. Good returns enable VCs to continue to raise new money to invest in innovate young companies and to perpetuate the innovation the cycle.  Returns are our constraint as VCs and we need to find creative ways to work within that constraint while still taking on the big risks that help to create new industries and completely revitalize old industries.

This is the challenge and it is a big one but one that will be exciting to work on.

At the end of Haque’s “Five Problems Post” he suggests that if VCs can’t solve problems like:

• Reinventing communications
• Reconceiving capital markets
• Business models for public goods
• Business models for radical responsibility
• Discovering new sources of advantage

than VCs are obsolete.  In fact, he says VCs are obsolete as of right now since we didn’t solve those issues.  I am not sure that he correct when he says that and I do think he trivializes the issues the VC business faces by ignoring the fact that VCs do need to provide returns that make sense to their investors.

However, I tend to look at Haque’s two recent posts as inspiration.  He’s right.  VCs can do better and VCs need to continue to strive to do better and to foster meaningful innovation.

I am not sure what the answers are in terms of working to reshape the VC business into one that address what Haque suggests VCs should be addressing. That said, I am willing to investigate the issues and to try to find some solutions that can get venture capital to the next level and I am sure many others are as well.  I am really glad that Haque and others continue to challenge the VC business.  It is too easy to become complacent and posts like Haque’s can really kick people into gear.

If a number of people heed Haque’s call some really exciting new ideas, businesses and industries will no doubt emerge and we (VCs and entrepreneurs) will continue to be able to combat the world’s largest, and most nagging, issues.

Reading time: 3 – 5 minutes

This is a question I have been hearing a lot lately and one that I have thought a lot about.  My initial reaction is simply that VCs are long term investors so we don’t freak out about these market fluctuations.  A couple other thoughts I had were simply that the limited partners in VC funds are so large that they will continue to be good for their commitments and that the IPO market is already non-existent so, from that perspective, things can’t get much worse with regards to the the IPO-as-exit exit strategy (however, they can get worse from the get-acquired-by-big-co exit strategy).

Matt McCall referenced a post today on his blog that came from PE Week.  The PE Week post did mention the “long term” comment and some others but also suggested that VCs and their portfolio companies have actually become smarter about business since the dotcom bust and that has helped them weather the current storm without too much worry.

Below you will find the four ways that VCs and portfolio companies have changed since the dotcom bust as published in the PE Week article.  The mindset is certainly different than it was in the bubble but in some ways it is still the same (just this week I saw a couple situations of startups acquiring startups which made me wonder a bit about exit strategies).

1. Better Money Management: Milestones matter to VCs. Ask any entrepreneur, and you’ll find it’s likely he or she are getting money in tranches based on deliverables. Most tranches go through, even when milestones aren’t met, but the process allows VCs a better way of keeping track of the progress of their portfolio companies. VCs are less likely to write mega checks in the early stages, many have raised the bar of proof points needed to get a big round. Money is also more likely to go to things that directly drive valuation increases as a smaller percentage of any round is going to PCs, servers and bandwidth.

2. New Sales Models: It used to be about “Big Game Hunting” and multimillion dollar site licenses. It’s a model that was great for vendors: get all the money up front, then worry about delivering the product. But Software as a Service permanently transformed the way IT was sold. Now new installations are cheaper and can be scaled slowly. It’s a model that’s been adopted by IT appliance and PC companies as well. So when Datamonitor finds that IT budgets aren’t going to rise in 2009 Datamonitor Survey , there’s less reason to freak out. Most IT buyers have already planned their spend out: it’ll be re-upping on the services they’re already subscribed to.

3. Decreased Addiction to Advertising: The banner ad was a big part of any dotcom business model. When advertising budgets fell, hundreds of online businesses shriveled on the vine. Now, online businesses look less to online advertising for real revenue. Google Adwords had a big hand in that. Suddenly it was a lot easier to install advertising on your site, but it was also less lucrative. Nobody ever got rich putting up Google Ads, but at least using the service saves companies from having to hire expensive advertising sales people. The addiction to advertising has been broken and many companies are looking for other ways to make real value online.

4. Moderate Exit Expectations: If you’re not looking to flip a startup to the public market, what do you care that Wall Street’s investment banks are falling like dominos? Had this same crisis had happened 10 years ago, you can bet VCs would be pulling their hair out. But when there are already no IPOs, it’s hard for the public market to get worse. When exit expectations are more reasonable, it’s easier to keep cash burn in check. Startups are less likely to build out sales teams, for example, planning perhaps to later plug in to an exisiting sales organization via aquisition.

Reading time: 4 – 7 minutes

Crain’s Chicago Business published a great article about technology transfer in the Midwest a few weeks back entitled “Seeking a breakthrough“.  The article specifically focused on tech transfer in Illinois and mentioned that, to date, Illinois has not done a great job of tech transfer.

Having come to Chicago from one of the most vibrant tech transfer centers in the world, Boston, MA (second only to Silicon Valley imho), I have seen what a great tech transfer system looks like and what it can do for the local economy.  Compared to Mass and the Valley we haven’t been doing a great job of commercializing technology from university labs (and from government labs) here in Illinois.

We all know the stories that still break our hearts.  Mosaic/Netscape, PayPal, YouTube, etc.  All of these companies were founded by Illini and yet ended up on the west coast.  The numbers also back up our lack of tech transfer.  From the Crain’s piece:

Between 1996 and 2006, Illinois universities spun off 124 companies and made $180 million from startups and technology they licensed directly to existing companies, according to the Deerfield-based Assn. of University Technology Managers. In that same period, the Massachusetts Institute of Technology alone started 220 companies and made $344 million. Stanford University made $209 million between just 2002 and 2006.

Those numbers say it all but we can (and will) turn this around.

What can we do to turn this around? One of the first things we need to do is not so easy.  We need to build some high profile success stories here in Illinois.  I would argue that is already happening with FeedBurner (acquired by Google in 2007) and TicketsNow (acquired by Ticketmaster in 2008) along with a handful of other solid companies that have exited recently (disclosure: DFJ Portage was an investor in FeedBurner and TicketsNow).  That said, those companies did not come out of university labs.  However, the success stories should still show people both in and out of labs and investors that great companies can, and are, built right here.

As the Crain’s piece suggests, more high profile successes in the state will create more technology millionaires who will then help to mentor and seed the next generation and so on and so forth.  This is the same way Silicon Valley and Boston, MA were born and why the biggest thing we can do is build some very successful technology companies here in Illinois.

The infrastructure is also being put into place to make technology in Illinois a mainstay.  The University of Illinois at Urbana-Champaign has built a fantastic research park and incubator (which I frequently visit and which will house TECH cocktail Champaign this week) as has the Illinois Institute of Technology (again, another place I frequent).  Both of these places along with other facilities are helping to change the tide of tech transfer here in the state.

What about the money though?  We all know that investors like to be close to their companies, which is why many Illinois startups have to leave the state to get up and running.  So we also need more investors here in the state.  The good news is that we are starting to see a growth in the investor pool here in Illinois.  From the Crain’s piece:

U of I created an independent fund, Illinois Ventures LLC, based in Chicago, with the help of private donors in 2002. Its goal is to provide early-stage money and logistical help to university-based startups.

Illinois Ventures has invested $20 million so far in 15 companies, among them Tetravitae Bioscience Inc., an alternative fuel company in Chicago, and has attracted another $300 million in outside investments, much of it coming from venture-capital funds on the coasts.

Ron Kirschner, a retired physician with an MBA from DePaul University, started Heartland Angels in Skokie in 2004. The group has grown from six to 22 investors and has put more than $3 million into six early-stage Midwestern companies. Four of those grew out of universities, among them Abiant Inc., a Deerfield company based on research from the University of Chicago and New York University. The startup uses imaging to help drug manufacturers improve products by mapping how they affect the brain.

I would also add the the Chicagoland Chamber of Commerce created a fund a little while back called the Illinois Innovation Accelerator Fund (i2A for short) which is a $10mm vehicle dedicated to funding innovative technology companies here in Illinois.

Also, as most of you know, the firm I am an associate with, DFJ Portage Venture Partners, focuses only on the upper Midwest and has for quite some time.  We are able to bring the global resources of Draper Fisher Jurvetson (DFJ) into the region while remaining locally focused, something we think will really help the region grow and help entrepreneurs create world class companies right here in Illinois (and throughout the Midwest).  As you can imagine we are very bullish on the Midwest as a technology center and we are excited to be part of the growing technology community here.

Successful technology transfer efforts will be a big part of what ultimately makes Illinois a leader in technology and tech transfer efforts are certainly getting exponentially better each and every day here in Illinois (for example Northwestern did a $700mm deal last year to sell part of its royalty rights to Pfizer’s pain drug Lyrica – a drug based on Northwestern research).

We are just now hitting the big upswing in the “hockey stick” here in Illinois and across the Midwest.  We are well on our way to rivaling the coasts when it comes to technology but we’ll no doubt do it our own special way making the Midwest a unique and exciting place to start and build technology companies.

Further discussion on this topic: Chicago Tech Report: “Understanding why Marc Andreesen left Illinois” by Blagica Bottigliero