wrong tool

You are finite. Zathras is finite. This is wrong tool.

More on valuations

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Fenwick & West LLP put together another survey on the state of Unicorn financing.

Here are the most important bits:

  1. Entrepreneurs are becoming managers of companies instead of owners. The exit preferences really show that the investors are buying the company with an option to sell.  
  2. Employees are really going to get screwed. Unless these companies are going to IPO investors are getting premium talent at a discount that only gets covered post IPO. And for employees who are looking at 10b exits these are rarer than a unicorn.
  3. Valuations are rigged to make the company look bigger to convince employees that the risk is lower so they join. We’re not an early stage startup we’re a big established company with massive stock upside (if and only if we net 10 billion post IPO)… Take this lower salary and smaller stock package because it’s a sure thing ™… Except it’s not.

Net net the game is rigged.

 

Valuation is irrelevant, pay attention to the terms

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One of my friends who happens to be way more plugged into the start up scene than I am, has been telling me for months to ignore valuation, but focus on term sheets.

A public company’s valuation is based on a simple formula  # of shares * share price. Any owner of shares can get a return on his investment if the company pays a dividend or if the share value appreciates. Pretty simple. The price of the share is decided every day in the market based on public data. Price goes up, you make money, price goes down you lose money.

A privately held company’s valuation is determined as a result of the negotiation between the investors and the owners of the company.

Part of the negotiation is what happens when the company gets sold or gets liquidated.

And this is the important bit. Something I have been ignoring.

Consider a company X that recently got 116 million dollars at a 2.76 billion dollar valuation. If the company gets sold to another company for a 116 million dollars a naive engineer like myself would do the following math:

.116 / 2.76 = % of company owned = approximately 4%

investors get back 116 *.04 = 4 million dollars

Investors lose 112 million dollars.

Except they didn’t. They lost 0 dollars.

Because the Term Sheet basically said that the first 116 million dollars goes to the investors. And after that 116 million do other people get money.

This makes the investment feel risk free because folks are assuming that in the worst case the company will not be worth less than 116 million dollars. The upside may be limited because the company has to be worth more than 2.76 billion but the downside feels manageable.

The risk free nature of these investments may explain why investors are willing to pile onto a firm like Company X. With downside limited, and a possible massive upside who wouldn’t want to get into the action?

 

Understanding Full Stack and the Evolution of Silicon Valley

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Over the last few months I’ve discussed the evolution of the valley’s innovation profile, mocking the term Full Stack, and bemoaning the collapse of investment in true hard core technology . And at times, I wondered if I was engaging in a form of #gamergate… I felt like I was whining that my club was being invaded and throwing an inappropriate hissy fit.

Yesterday I went for a walk with a brilliant friend of my wife’s and as often happens when you talk to someone who is effortlessly smarter than you, things that were unclear become clear.

Let me start with what the world used to look like to my grandfather.  But … First let me talk a little bit about my grandfather Kostas Roussos.

Kostas  worked at NCR in Greece from about the early 30’s to the late 70’s. He was personally responsible for transforming the back office’s of hundreds of large enterprises across the Eastern Mediterranean and North Africa. In what could only be described as bizarre, IT and tech, in many ways, is a family business …

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In his world, there were businesses that produced products that moved the product to middle men that sold the product to consumers. Those businesses had three basic layers, a sales/channel team that sold the product to middlemen, a product development arm that built the product, and a back office that supported both with things like billing and legal support etc.

The problem a lot of those companies had was how to make their back-offices more efficient and reliable. At the time they relied on human beings to tabulate figures and close the books. And errors, and theft, and inefficiency were rampant. Enter NCR with it’s automation systems and all of a sudden back-offices became more efficient freeing up dollars to spend in product development and sales/channel activities.

The entire business IT/Tech industry emerged as the way to fix back-office systems across the world.

The folks at IBM/NCR understood this world very clearly and understood how to sell to that world.

To my grandfather, each of those companies were ‘full stack companies’. Where the stack, in his mind was all three layers: sales, product development and back-office.

When building a company you had to build all three layers. And one of the hardest layers to go build was the sales channel because the incumbents owned that channel. You had to go basically flip one sales guy at a time, one day at a time.

But in 1993 the world changed.

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What the web did was that it allowed you to reach customers without building a sales channel through advertising. Essentially you could build a company that looked like this:

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The theory was that you could directly reach customers who would find you because of how you spent advertising dollars. And as a result, you could more efficiently scale your business because the painful and slow process of sales channel creation could be bypassed entirely. And the other theory is you could capture more value because you could avoid paying the middleman.

Who can forget the phrase “disintermediation”…

What happened was that real companies tried to re-engineer their back-offices to be able to directly sell to their customers bypassing sales channels and middle men. Who can forget the whole ‘what is your web strategy’ and ‘e-business’ ads from that era?

Most of the investment from a tech perspective in that era was technology to improve the back-offices or to create middlemen (web-portals!) that would be where people bought advertising dollars to reach customers.

What is ironic of course is that it turns out that the scale and volume of the businesses that were trying to advertise was so gargantuan that a middle man did emerge, possibly the most powerful and rich middleman of all time:

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Basically Google became the middleman of the new era.

And so the world looked a lot like what my grandfather remembered:

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Once fortunes become titanic, then of course competition emerges. As entrepreneurs saw the staggering value available in being Google, competition emerged to try and take a piece of the action. And so companies like Facebook and Twitter and Yelp and God knows who else have been trying to own a piece of the middle man action ever since.

Except of course the sales and channel still remained super critical for most people because you don’t buy things from the web unless it’s a pure commodity…

In the modern era, then the Valley has either funded companies that tried to improve your back-office infrastructure or tried to be a better middleman for the electronic era. And those were ridiculously profitable areas of investment.  Because a small amount of capital could produce very quick returns. And ultimately, VC’s are just middlemen between owners of capital and entrepreneurs and rate of return is important to their customers.

As an aside, what’s astonishing about SaaS is that we are able to achieve the same rates of quick returns that middleman companies used to enjoy in selling to the back-office. The idea that you can grow that fast into the enterprise back-office is nothing short of astounding and mind-blowing.

Returning to our original story… if you think about it, the valley has never really made its specialty investing in building companies that built products that didn’t fit into back-office or middleman kind of areas.

Although it is inevitable that we would eventually build full companies. As we became middle-men, we would see opportunities for products and eventually some of us would want to build the product.

And this is a new thing. Tesla, for example, is a full stack company in that the core of the business is building a car. Alt-School is another example, the business is building a school, IT is just back-office stuff that makes it better.

 

 

yes, being a middleman is lucrative 

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the Internet is a Twitter when Tom Goodwin  discovered that being a middleman is very lucrative. He called it a user interface and thus its new.

Amazing.

This is similar to how we call a business a full stack business in the valley. And equally absurd.

My great grandfather who made a fortune being a middleman between the Russian nobility and western purchasers of grain and got my grandparents out of grinding poverty and made me would be … Amused.

Being a middleman is lucrative. And what is amazing is that the web that was supposed to disintermediate middleman has made them more powerful than ever.

And yes, having a great relationship is key to being a great middleman. The user interface, in our digital age, is the way to have that relationship.

Grandpa Iannis would have been proud. And disappointed I never became a middleman.

Misunderstood Math and Big Data

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Over the last year, I’ve met a number of autodidacts in the big data space. They take some big data database, grab some statistical method they poorly understand and create chaos.

The problem is that an army of systems engineers have made it possible for people who don’t understand statistical methods or machine learning to use tools they are woefully unqualified to use.

My wife called me up yesterday to tell me this joke about physicists and mathematicians.

Thing is I had heard this joke many, many, many years ago that I found amusing but not super funny. And yet when she told me to think about all of those big data projects, I died laughing. When she got to the punch line, I was laughing so hard I couldn’t breathe.

 

MoneyBalling Recruiting Engineers or looking for Usain Bolt

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Usain Bolt is possibly a fascinating athlete in sports. His body is just wrong for running sprints. He’s too tall.

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And yet some coach decided to overlook his body type, and records fell by the way-side. So much so that I have to believe that coaches worldwide are now looking for tall, not short, sprinters.

I recently saw this post float by Twitter on secretly terrible engineers. The general thrust of the article was that perhaps the interview process was profoundly broken in some way.

And then there was this exciting follow-up on grey beards and the use of questions that only a college grad would be familiar with as a way not to hire grey beards and approach to find out who is ‘old’ without asking their age…

And I thought about money ball. In money ball, Billy Beane questions how we select people to make up baseball teams and radically transform the sport of baseball opening it up to players that we would never have considered in the past.

The current recruiting system is running up against a brick wall of supply. At this point, we don’t have enough people graduating with advanced degrees in CS. As Kate Heddleston puts it so well, we are running out of people who can do the 100m dash who fit the 100m dash profile.

I believe that there will be a strategic advantage for the first tech company to figure out how to hire people who do not fit the 100m dash profile. That company will recruit more people more efficiently and get more out of them than any other company. Unlike outsourcing, which companies did to drive costs down and therefore easy to replicate, I genuinely believe that this will be disruptive in a way that we can’t imagine. Hiring, promoting, rewarding, and training people will be different. I wish I could tell you what it was, but as a beneficiary of the current system, I don’t know and can’t imagine. I know it will be different.

My only hope is that I will be able to adapt and not be like those short guys watching this tall dude blow past me…

Bubble bubble toil and trouble

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Earlier I wrote about early stage valuations being de-risked through schemes similar to how mortgage backed securities were derisked and how that was creating a bubble. The reason derisking creates a bubble is that  by artificially de-risking a high-risk investment, the amount of money that can be invested increases significantly.

To speak in math: if the total amount of money to invest is MONEY, and only 10% of MONEY can be invested in high risk investments, then only 0.1*MONEY is available to invest. Now suppose I can take an investment vehicle, like an early stage start-up, and de-risk the investment, then instead of only 10% of MONEY being available to invest, 30% or 40% of MONEY is available to invest. The net effect is to increase the total amount of money entering the market creating an asset bubble.

If the total amount of MONEY is also increasing (thank you QE), then you have two accelerators – the derisking making more money available and more money coming online…

As for how to derisk an investment … 

There are two ways to derisk an investment. The first it create a hedge. The second is to foist more risk on some people and less risk on others. So for example, in the mortgage backed securities market we had both. We had credit default swaps as a hedge, and senior debt as a way to derisk the investment for some. In the early start-up game, the hedge is to invest in many different start-ups in the same space, and the derisk strategy is to have warrants on any early liquidity the company may get.

Essentially the investor is pushing more risk on the employees and founders by being first in line to any money the company makes.

But there is another way to derisk … 

The other way to derisk is to believe that something is less risky. Essentially we take leave of our senses, and believe the hype that surrounds us. This second form of derisking is far more dangerous and far more explosive.

After I wrote my little note, this made the rounds: https://www.linkedin.com/pulse/investors-beware-todays-100m-late-stage-private-rounds-bill-gurley where he seems to be arguing that traditional risk analysis is being ignored in favor of a devil-may-care must-invest-at-all-mentality…

And it all leads to this: 

The author, Bill Gurley,  had this money quote:

All of this suggests that we are not in a valuation bubble, as the mainstream media seems to think. We are in a risk bubble. Companies are taking on huge burn rates to justify spending the capital they are raising in these enormous financings, putting their long-term viability in jeopardy. Late-stage investors, desperately afraid of missing out on acquiring shareholding positions in possible “unicorn” companies, have essentially abandoned their traditional risk analysis. Traditional early-stage investors, institutional public investors, and anyone with extra millions are rushing in to the high-stakes, late-stage game.

With the downside for the investors being derisked either through hedges or warrants, and the risk of poor outcome being pushed on the employees and founders, the companies are actually being forced to take bigger risks and by taking bigger risks …

But why?

Remember what I said earlier, with warrants when a company has a liquidity event the early investors make most of the money. Consider a hypothetical company that has it’s paper set up in such a way that any liquidity event up-to 500 million dollars the employees get to split less than 50 million dollars. The employees and CEO are now motivated to go after a billion dollar outcome.

And So?

The problem is that it’s a lot easier to hit 500 million dollar exits (historically speaking) than 1 billion dollars.

So the CEO decides to go for it because only if he goes for it does he make any real money thus he increases the risk

The problem is by going for it – he actually is increasing the risk of complete loss.

So ironically by derisking the investment the overall risk is actually increasing.

Somewhere Nassim Nicholas Taleb is smiling

 

 

How no-risk is creating fake unicorns in the valley

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Thoughts about bubbles and unicorns in the valley.

A bubble emerges when folks make investments that are risk free and have high yield. The appetite for mortgage backed securities was tied to the need for yield and the way in which the underlying asset was assumed to work. Basically the idea was that there was an upside risk but no real downside risk especially for the owners of the senior debt. And so people bought the asset figuring that in the worst case they made no money.

One of the interesting phenomenons in the current  in funding bubble is the assumption that because of the scale of companies there is no risk to the investment. There may be marginal upside but the downside risk is marginal.

For example, one view of the SnapChat investment is that in the worst case the company is worth a couple of billion dollars. If you can structure your investment in such a way that you get your cash preferentially when the company gets sold, then as long as you get your millions your okay.

Because I don’t actually understand the details of the SnapChat investment, let’s talk about company X.

Suppose you invest 10 million in company X at 2 billion dollar valuation. Your upside only exists if the company is worth more than 2 billion – unlikely but still plausible. Your downside, on the other hand, may be significantly less risky. If you believe the company will get sold in the worst case for 10 million dollars and that you are first in line for the 10 million dollars, then this is a risk free investment. You simply can not lose your money so why not take the risk?

The beauty of this arrangement is that it works great for everyone. The founders get the cash they need without having to dilute their equity in the company. Presumably 10 million at 2 billion valuation means a lot less stock dilution than 10 million at 20 million valuation. The VC’s get to show growth in their portfolios – especially if they made an initial investment at 100 million. Just to make that point a little bit clearer – they invest 1 million at 10 million valuation, then 9 at 2 billion and their initial 1 million investment appears as a paper profit of 20 million dollars.  And the employees get to feel that they are in a  rocket ship that is going to outer space. And the LP’s in the fund get to see growth with no risk.

The downside, of course, is that the risk free nature of this investment may be a mirage. For example, the company may not get acquired for 10 million dollars, it might become vaporized. Or worse.

When everyone believes in the downside risk thesis we have bubbles. If everyone believes there is no risk and there is a lot of cash around – thank you QE – then we have a bubble because you become stupid to not invest in risk free investments with high potential yield.

Since I am fan of the black swan books, my belief is that when too many people believe in no risk, then risk gets magnified and disaster emerges.

We’re not there yet, we are in a boom – the danger is the boom turns to bubble before it becomes a bust.

 

Here Comes Another Bubble: More data

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When you look at the startling increase in dollars being pumped into seed start ups as compared to the rest of the bay area economy, you know we have a bubble.

And then there is this data shared by Thomasz Tunguz.

Start up office space has grown 12% CAGR and Start up salaries have increased 15% CAGR over the last five years. Just to make this real for those of us who still earn the bulk of our money from our salaries, in 2009 a start up was paying 90k a year and in 2014 a startup would be paying north of 170k.

If these increases were driven by customers buying products, this would be a good thing. Except it’s not. These increases are driven by an increase in funding levels. Essentially more VC’s are being given more money to put more money into more start ups.

Given that these price increases are sustained by increased funding levels not increased revenue levels, this will end in tears.

The funding spigot will end at some point in time. And when it does we will have three corrections

  1. A sudden and dramatic collapse in employment as start ups get vaporized.
  2. A sudden and dramatic collapse in salaries as more people chase suddenly fewer jobs. The jobs they had will disappear and the new companies that start up will hire at rates that are more like 2009
  3. A sudden and dramatic collapse in office real-estate

The only good news is that traffic will get better for folks who are able to stick around…

The end of Silicon Valley, Long Live Entrepreneur Valley

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There is this discussion going around VC circles about full stack startups. The notion that the business doesn’t just build a gadget but a complete end-to-end business. This a profoundly different kind of business investment for the valley and worth mulling over…

Over the last fourty or so years, Silicon Valley has been about making technology investments. Companies were created to build things that other businesses turned into products that real people consumed.

Put differently, technology was created to be in the service of a business like Starbucks. Silicon Valley built the technology that enabled Starbucks to sell more coffee, better treats and yet Starbucks is just another entrant in the restaurant business. Essentially companies outsourced their IT engineering budgets to high tech Silicon Valley companies.

The emergance of companies like uber and airbnb and altschool and Luxe and of course Amazon are not about technology companies but instead companies that happen to leverage technology. These companies may have a tech budget but their business, their products and the bulk of their staff are not technology. They use technology, they may invent technology but engineering exists to serve. Engineering is a service inside of the business not the business…

Sure tech is important to uber but the drivers are vastly more important…

These are just normal businesses that happen to get funded by VC’s… They are not traditional high tech companies…

As more of these companies get founded and succeed the valley becomes more about a place where entrepreneurs set up shop and less a place where technology gets built. As investors look to find the next business to fund instead of the next piece of innovative technology there is a real risk to the original valley ecosystem… No longer are technologists the winners but conventional business men…

Over time if this pattern holds these business men will succeed and become investors who will look to create more businesses that happen to use tech or… not.

After all our current business heroes are not guys who built technology but guys who understood a business need and found some tech guys to build it. Heck when Twitter paid 10 million for A VP of engineering the discussion on business insider . com was about how overpaid he was. I mean seriously no engineering leader should be that much – because they are just a service to the business after all….

The demographic and the core of what is the valley will change and the path to success will change.

We engineers that created a small corner of the world where geeky engineering could rules will find ourselves displaced by a new very different kind of world.

Engineers may become relegated once more to being shoved in the back room while the real power within companies has meetings…

Then the question remains what does this portend for future tech investments? My gut tells me that we will see a movement of investment outside of the valley over time. As this becomes home to large conventional businesses and investors pursue more of them… The guys who want to build tech will move elsewhere because their ability to find people and get investment will be better elsewhere. The valley relied on engineers investing in each other…

My wife says change is what you can rely on. And this change feels real andd it does mean that the future will look very different….

Still remaining bullish for the valley, I am just no longer certain the term Silicon will be appropriate… Maybe entrepreneur valley…