wrong tool

Great post here by Mark Suster at Bothsid.es

Lots of good stuff here.

My key takeaway is here:

The vast majority of this recent boom in prices is not being driven by VCs but rather by hedge funds, mutual funds, corporate investors and other sources of non-traditional venture funding. In the chart below you can see that a decade ago for every dollar a VC raised from LPs a dollar went into a startup. Now for every dollar a VC raises $2.50 goes into a startup.

Many moons ago, I wondered where the hell the money was originating. Mostly non-VC money chasing yield has descended on the valley. And like the sub-prime mortgage crisis, the non-VC money figured out that using preferential terms allowed them to invest in riskier assets with less risk.

Shifting risk, and increasing the value of assets without increasing their value never ends well.

 

 

 

 

 

A friend of mine and I have been debating unicorns for months. And what we concluded is that there are two stories.

The first story is that there are a bunch of excellent businesses that are worth billions. These are the true unicorns. I won’t hazard a guess of how many or which companies fit that bill.

The second story is that there are a bunch of donkeys with horns that are using creative deal structures to acquire valuations that are questionable. And that the story of the true unicorns is hiding the story of the donkeys.

The recent article on TechCrunch tells us that the number of potential donkeys is on the rise.

And so my buddy and I debated the impact of these potentially faux-Unicorns.

The first narrative, dominating the press, is the effect of faux-Unicorns on investors. After a lot of discussions, we concluded that the recent faux-Unicorn phenomenon of artificially constructed valuations is benign to positive. Positive because it mitigates the downside risk, and because it captures more of the upside if an acquisition occurs at the cost of investing more capital in a business that has achieved a certain amount of success.

 

If you take a unicorn job in 2015 and never say the words “liquidation preferences”, you are the sucker at the table https://t.co/cbh3lPRA9a

— Alex Stamos (@alexstamos) December 24, 2015

 

 

The second narrative that is emerging is the impact of faux-Unicorns on employees. There we agreed that the story is downright appalling. The shift of risk from investors to employees who find themselves locked in, or worse, have their interests misaligned with the core investors, or even worse is not positive.

The derisking for investors and founders is increasing the risk of employees.

And so what?

The danger is that employees eventually figure this out. And they start demanding higher salaries, longer periods between when they quit and when they have to sell their shares or just plain refuse to work for any private company.

Furthermore, as more employees figure out that a Unicorn or a startup is not a path to riches, and that the investment strategies are being used that minimize their already minimal chances of wealth, people will over the long-term lose interest in working at startups.

And worse, because employees are not investors they have a hard time disambiguating faux-Unicorns from real Unicorns.

If a startup is a job where you work long hours, at low pay, to change the world, there are a lot of options that are not working in tech.

We can talk about culture, and opportunity and learning and if there is no money, then people will go elsewhere.

The people who work in the tech sector have the ability to do anything they want. And eventually, they figure that out.

 

 

 

In my career, I’ve chosen to work at larger companies instead of smaller ones. Or maybe, a better way to describe it, is that I have joined small sized businesses that became enormous.

And I was reflecting on the differences.

My favorite game of all time is Civilization II. Some players, like the beginning game:

The point is that you have the fewest pre-existing constraints. You can only make a small number of decisions. And each decision is a matter of life or death. You can very easily get destroyed if you make the wrong choices.

That part of the game is the most intense because every decision is, of course, critical, every moment obviously a life or death moment. You choose to explore a village, and if it turns out to be barbarians and you don’t have an army you lose the game.

In the later phases of the game, you have many cities and an accumulation of decisions. You can quickly destroy other civilizations, build wonders, and typically there is no existential threat. No decision is obviously existential. No crisis is obviously critical.

There are existential threats; they are just not obvious.

The challenge in this part of the game is how to marshall resources and make decisions to win the end-game while ignoring things that are not important.

When you join a large company, you are essentially being given someone else’s Civ game. Your job is to figure out what decisions your predecessors made that are prescient and build on those while figuring out what new decisions need to be made to win.

The funny thing about joining a Civ game in the middle phase is that you may have already lost. Some decisions made early on may have put your civilization in a terrible spot that are only obvious now.

And for many folks, this makes starting a game more attractive than taking on an existing game.

The funny thing is that when you launch a new game, the computer makes decisions for you, and those decisions, when combined with your preferred strategy, will doom you just as much.

The thing about the early part of the game is that when you lose you’re just a historical footnote, a leader of a small tribe. When you lose later on in the game, you may have a large thriving civilization that just didn’t make it to the finish line. You fail as a CEO of 10 person startup, and only your web page records your failure. You fail as the CEO of Yahoo, and it’s front page news on the WSJ.

The later part of the game in Civilization II can be more thrilling. You get to do more stuff, try more things, you are on a bigger stage and you are playing for all of the marbles instead of a chance at all of the marbles.

 

 

 

 

 

Yesterday, I wrote about the problems with Unicorns and their preferential treatments of investors.

Today, I wanted to make the asymmetry realer.

Consider the decision facing the board when it had an 825 million dollar deal on the table.

The board was considering four options in that order

1. Go public and be valued at more than 1 billion
2. Accept an 825 million dollar deal
3. Sell at a lot less
4. Keep struggling alon

The board, probably feeling optimistic decided to skip the 825 million dollar deal because the board felt that the upside of an IPO was worth the risk.

The question is what risk was the board considering and are these aligned for all stakeholders.

For the preferred investor, option 3 is more valuable than option 4 and for the employees option 3 is not an option worth considering.

Let’s explain it with numbers.

If the deal closes at 825 million, preferred investors make ~4$ a share. If the deal closes at 425 million, the preferred investors make 3$ a share. If the IPO happens, the preferred investors may make 5$ a share.

If you think that an IPO has a 20% chance of happening and a 425 million dollar deal has a 70% of happening then what you are doing is saying I am taking a chance at 20% upside with a 25% downside. Not a bad bet. Especially, if the downside bet is still a positive outcome. Option 4, continue to go at it is the worst option because the downside risk is to lose everything.

For the employees, however, an 825 million acquisition is worth 4$ a share, and a deal at 425 million is worth 0.44$ a share and is no different than struggling along. Your stock is worthless at 425 million so you might as well keep trying.

And if I were an employee, I would like the choices the board to be 1, 2 and 4, whereas the board is incented to choose between 1, 2 and 3.

And because the employees are not a stakeholder and not even a shareholder, the right decision for the preferred investors was made.

In all of my posts, I keep pointing out that the problem with a Unicorn is that the board structure and ownership structure is not aligned with the interests of the employees who are not senior investors. For the most part, employees are junior investors. And in any liquidity event, the senior investors will be made whole before the junior investors.

The latest Unicorpse, Good, is a good example of  the problems with boards. The employee interests and board interests are not aligned.

Preferred stock is different from common: Since Good’s venture-capital investors were first in line to be paid back, turning down the deal in March was less risky for them than it was for common-shareholder employees. Both the preferred shareholders and the common shareholders would do much better at $1.5 billion than at $825 million, but the preferred shareholders wouldn’t (and didn’t) do too much worse at $425 million than at $825 million. The common shareholders did much, much worse. As Felix Salmon says, “the huge problem is divergent incentives between common and preferred,” and the board of directors was aligned with the preferred.

Remember the preferred investors have different interests than employees. Employees want to maximize their investments. A startup is an attempt to make a lot of money. An investor has other interests and may want to liquidate a position.

For example, a preferred investor may want to free up capital for better investments, or may want to return money to LP’s or get out of an investment. And in those scenarios the Good exit, is a reasonable exit.

And so we have the perfect storm. The Good preferred investors took a calculated risk with limited downside when they turned down the 825 million deal, unfortunately, for the employees, the downside risk of not taking the 825 million dollars was much larger. When the deal closed, the preferred investors didn’t do badly. The employees got screwed.

The current funding environment is very dangerous to the valley and to employees.

As always, double check the fine print, understand the board motivations and make sure that you go into any situation with your eyes wide open.

 

In Dana Jr’s book, we learn of the power of the captain of a ship to control his employees. Stuck on a boat, on the edge of the known world, with no way to get back home, the sailor lived and died at the whim of a captain. And what struck me, as the most horrifying part of all, was that a sailor who signed on for two years could suddenly find himself signed on for 10 or 12 if the captain os the captain’s employers so decided.

Employees at startups are like sailors on a boat. The early founders are like the captain sitting behind the mast in their more comfortable digs. The investors are like the people who invested on the journey and expected the captain to return with something. The employees are like Dana Jr, promised a fun trip and profit while living in squalid and miserable conditions.

Wired just wrote about what I have been talking about for some time; the system can be very rigged against employees.

Again, every company is different. And you should have your lawyer or an HR person who does not work for your new employer review all and any of your paperwork.

Why write about this again?

1. Companies are staying private for 11 years. And why not, the senior investors – founders and early investors – don’t have to IPO to get liquidity. Mezzanine investors and later employees are stuck waiting for a liquidity event for a very long time. There is a big difference between 4-5 years and 7-11 years
2. The secondary market that I hoped would help is closed.
3. There is nothing to push a private company to go public with the JOBS Act. The 500 shareholder minimum got removed.  A private company that has access to capital is cash rich, and whose core founders and investors are well off, has no reason to go public. For a consumer company, that is particularly true. For enterprise customers, potentially less so. Customers of enterprise customers like to see your financials before they buy your products.

You can get stuck in a Roach Motel if you work for a startup.

There is a real danger here.