Buttonwood has posted an excellent analysis of why financial markets are unlike other markets for goods and services:
This apparent contradiction can be resolved. Financial markets do not operate in the same way as those for other goods and services. When the price of a television set or software package goes up, demand for it generally falls. When the price of a financial asset rises, demand generally increases.
Which explains why bubbles develop and burst and why ‘market fundamentalism’ does not generally serve us well when thinking about financial markets (as opposed to other markets.) Buttonwood also alludes to the fact that bubbles often develop at times of great change (has he read Perez???):
Why not just let the markets rip? Some would say that bubbles tend to coincide with periods of great economic change, such as the development of the railways or the internet. Individual speculators may lose from the resulting busts but society gains from their overoptimistic investments. However, this argument is harder to sustain after the recent bubble in which society “gained” some empty condos in Miami and holiday homes in Spain.
His conclusion is that because of these structural characteristics of financial markets, central banks (and possibly regulators and/or governments) have a natural, pro-active role to play in trying to mitigate or counter these problems.
Of course a few investors – the most high profile being Warren Buffet – have successfully arbitraged this weakness in capital markets buy being countercyclical, being “greedy when others are fearful, and fearful when others are greedy”; but as most people know this is bloody hard to pull off and exposes the investor to significant liquidity/solvency risks if they get the timing wrong. As Keynes said, “the markets can stay irrational, longer than you can stay solvent…” If you have an edge, even a small one, doubling down will usually work as long as you have an infinite bankroll. Ooops, small fly in the ointment. (Besides, if you have an infinite bankroll, what the hell do you need to bother about worrying about returns!)
Well I have neither an infinite bankroll nor the skills (and/or luck) to adopt a Buffet-esque investment strategy. But I do have some skills. And some experience. And I can recognise patterns reasonably well. And I have conviction. And a reasonable track record for building new markets and adopting and executing novel business models. So a few years ago I figured out that by focusing these modest talents and skills on investing in and helping to build new businesses, with a lot of hard work and days and months of research and reading I could generate pretty decent financial returns that were (almost) completely uncorrelated with the massive tides that buffet the world’s financial markets. And most importantly, this lack of correlation is structural – ie it doesn’t disappear in violent bear markets when almost all mainstream asset classes discontinuously jump to near perfect correlation (much to the chagrin of the VaR boys.)
It’s not hard to understand why. In fact it’s pretty obvious. For a new business, the ups and downs of the market, GDP, etc. have at best a second or third order effect on the company’s value. These factors are overwhelmed by the single most important factor driving value creation which is of course, can the company successfully sell it’s products or services to paying customers (or be more and more clearly on that path.) As someone wise once said: a “start-up is not GM” ie They are not correlated to GDP.
Now don’t get me wrong, I’m not suggesting that investing in new companies is without risk. In fact as most people would glibly observe, investing in start-ups is ‘very risky’. Well yes, but the risk is almost entirely idiosyncratic and manageable – much much less dependent on vast, uncontrollable, macro-economic trends and forces. And just because the risks are easier to identify and name, doesn’t mean it is easy to manage them, just that they are potentially (more) manageable.
So if this is true, why have venture capital returns generally been so poor (at least in the last decade or so) and why don’t more smart people try their hand at this (rather than trading/managing other types of assets)? Answering the second question first, I suspect this is because failing together is much nicer than failing alone, and so if the global financial crisis wipes out your hedge fund or investment bank or savings, well that sucks but, you know, shit happens. If however you pour your own (or worse your investors’) capital into a couple of dozen new companies that crash and burn, well that’s just a very lonely place to be. The answer to the first is not simple and you could probably write a book on this (perhaps Paul Kedrosky will?) but with the disclaimer that I don’t pretend to really know, my short and dirty take would be that there are two related factors at the heart of this failure. First, investing in new companies is hard to scale – at least compared to many/most other asset classes and secondly, the traditional structure of the industry is poorly adapted to this reality. Private equity legal and economic structures (which is how most venture partnerships are structured) doesn’t really fit the risk/reward/resource profile needed to invest successfully in new companies. Of course their are exceptions – both temporal and human – but just because their are some investors clever and/or lucky enough to make it work doesn’t make it right.
I could of course be wrong. And I could fairly be accused of hubris, especially as at this point I don’t have a long enough track record and/or enough exits to prove without doubt that my approach is correct. And while I am confident in my own abilities and have backed that up with a lot of “skin in the game”, I am even more confident in my larger analysis that while the venture capital industry might be broken / poorly organized, the risk-adjusted returns available to those who chose to invest – methodically and with a well-calibrated capital and incentive structure - in new companies, are excellent and, for the VaR-boys out there, truly uncorrelated to mainstream asset classes. The challenge is of course to find these investors and not to swamp them with too much capital. This problem isn’t solved but it looks a hell of a lot like the problem facing hedge fund investors (in most strategies that also do not scale beyond certain amounts of capital) and the asset allocation community would do well to try some of their more successful solution there on finding and seeding managers in this asset class.
And if you ask me, the rise of the ‘super-angel’ much talked about in venture circles these past months, is a step in the right direction and perhaps an indication that asset allocators are (finally) waking up to this opportunity.
Today I had the opportunity to be on the other side. Presenting our CiRX idea at mini-seedcamp London; attending as a ‘founder’ and not an ‘investor’ or ‘mentor’ for the very first time. And it was totally worth it. Not only was it valuable in the normal / traditional ways that seedcamp can help a founder but interestingly – although not altogether surprisingly – as an investor, it was very enlightening to sit on the other side of the table for once. I learned a lot. About CiRX of course but also about how a founder perceives the world (as opposed to an investor.) The only regret I have is that I don’t think I did a very good job of being mentored, especially with some groups and wish I could have another go. (Basically I talked too much. I know. Shocking.) Partly because well, I unfortunately do that sometimes, sorry. Partly because at almost a subconscious level, while I was supposed to be the mentee, my default tuning in this context is to be the mentor so sometimes I perhaps did both! And partly because I haven’t yet nailed the best way to succinctly articulate the value we see in the CiRX proposition.)
This last bit was a great takeaway because even though I probably knew that before, I definitely know it now and having muddled through a half-dozen live sessions has already now given me some ideas of how to better describe and deliver the value proposition of CiRX. Indeed it was funny to fall into the exact same trap I’ve (patronizingly? hope not!) warned so many founders about myself: ie to remember that 99% of the people you will speak to about your vision haven’t spent the last 6 months bathed in it and so the threshold of obviousness is much much higher than you think it is. What you take as given, is anything but to most people you will meet. In any event, I would highly recommend that anyone investing in early stage companies walk a mile in those shoes. A bit humbling, but more importantly very enlightening.
I’d like to thank all the mentors whom we met and really underline how much we appreciated their forthright opinions and incisive analysis. Farhad and I got a lot out of it and I suspect that we will tweak our plans based on some great insights and suggestions we received throughout the day. Also at the risk of sounding a bit soppy, I’d really like to publicly thank Reshma and Saul for the incredible job they have done building the seedcamp community and ecosystem. I am reminded of the summer of 2007 when I made a rash decision to invest in this new thing a guy I barely knew named Saul (who admittedly had come highly recommended) was organizing and thinking now what a terrific investment that has been. And that’s before getting any of my capital back!
Finally, I just have to say how impressed I was by the quality of the other teams that were invited. Really really impressive. Not so many in our investment space (although Subsify is a company that caught our eye and we’ll be interested to learn more about) but the two that really stood out for me were Editd and Memrise. Would be very surprised not to see these two make it through to seedcamp week in September. Eyequant too.
As for us, well we certainly have a lot to digest and a lot to work on…but that’s exactly what we hoped for.
You may have noticed, I haven’t been posting much here lately. It’s not that I don’t have anything to say, probably just the opposite (!) but have be full out from dawn until dusk working on a number of exciting new projects including our own development (more on that in a few weeks.) One project that has been front of mind the past few weeks is a new company we are developing that is directly inspired by Paul Graham‘s great advice to “solve problems that affect you directly”.
A bit of background. When I was in banking, one of the achievements I was most proud of was effectively using web technology to transform how (debt) capital was raised (at least in Europe*.) At DrKW, we built what for many years was the state of the art capital raising platform, whose core product was our eBookbuilding platform (now in Commerzbank yellow!) It completely revolutionised what had heretofore been a disjointed, manual, somewhat ad hoc process into a seamless, collaborative, mostly painless process. Initially it met with enormous resistance from other (much bigger and more successful) banks and syndicate managers, who as ‘guardians of the temple’ jealously guarded their power, derived (in their minds) from the information asymmetry they enjoyed (vs issuers and investors.) However – and despite being at best a middling player in the fixed income new issues market – our disruptive technology was such a big improvement on the status quo that eventually the market adopted our standards (with everyone then rushing to build their own analogous platforms.) In the spirit of making sure these platforms could ‘play well together’ we even published our XML-Schema for new issues and invited all our competitors to contribute to it and use it. (Which had the effect of basically freaking out our competitors. They thought we were crazy – like Ali – because they didn’t have the slightest idea what it means to compete in a world of information abundance and platforms, but that story is for another day…)
Anyhow, when I became seriously and then professionally active in ‘venture capital’ or more generically speaking, in investing in private companies, the lack of technology available to manage workflows surprised me; I was particularly puzzled because ostensibly this was a world populated with techophiles, early adopters and people who ate disruption for breakfast (quite unlike the world of institutional capital markets). Further, there is much talk (and consensus) around the fact that it is hard/impossible to scale venture investing. And while I think this holds at some level, it struck me that a significant number of the gating factors limiting the ability to scale could be vastly improved. Not to infinity but substantially, perhaps by an order of magnitude. Pulling out an example from my old career, when I started life as a bond trader 20 years ago (ack!) the number of bonds that a typical good trader could manage numbered in the dozens at best (and even then, you would find that a trader really traded 10 to 20 bonds 80% of the time and sort of went through the motions for the other bonds hoping most of the time not to trade.) Then came Bloomberg. And excel spreadsheets. (And later bespoke pricing and analytic tools and platforms.) And all of the sudden, a trader could manage a book with hundreds of securities. There was still a degree of 80/20 but everything was an order of magnitude bigger.
I don’t know if our new initiative will definitely achieve that degree of change in the private investment market, but we are convinced that there is a better way and having a fit-for-purpose platform to help company management, non-executive directors and investors communicate, collaborate and manage their positions and responsibilities would be a huge step forward. It’s not that nothing currently exists, but I would say we are at the ‘excel spreadsheet’ phase to use my bond trading analogy – with many firms and people starting to use things like Google Apps or Basecamp and the like to better manage information flows and collaboration. But while this (and excel for traders) is (was) a good start, the real juice comes when dedicated, purpose-built platforms emerge. If you have a screw that needs driving, a hammer is better than nothing (or a rock) but a screwdriver is even better! (A power screwdriver better still!)
So we conceived of (what has been provisionally named) CiRX – the corporate director and investor relations information exchange:
CiRX is a purpose-built platform enabling private companies, directors and investors to communicate and collaborate more efficiently saving time, money and effort. By streamlining processes and connecting stakeholders in an intuitive and context-rich environment, CiRX offers a tailored yet consistent solution to the challenge of managing information and documentation flows, reducing administrative burdens and creating opportunities for a richer, more dynamic and flexible approach to corporate governance and strategic management.
Over the past few months, we have been developing the concept, the business model and have done a significant amount of macro research to identify the potential size of the market opportunity and now have started to take the next step and ‘talk/think details’ as they say. In order to support this next stage of development, as we are poised to start ‘cutting code’, we wanted to get more direct feedback from the community – of company executives and founders, non-executives, angel and institutional investors – to better understand how their experiences and perceptions were both similar and different to our own. To do so we created a short(ish) survey and have sent it to a number of our contacts across all these communities, but if we missed you and you are a company founder or non-exec director or investor in one or more private companies and you are interested in contributing your views, you can find the survey by clicking here.(We’ll leave the survey open for a couple weeks probably but if you are so inclined to complete it, we are excited to be presenting CiRX at mini-seedcamp London next week so would be great to have as much feedback as possible before then.) Of course you are also welcome to share your views – good, bad and ugly – in the comments below.
* That e-bookbuilding (generic) never gained acceptance in the US (at least not while I was still in the market) is in my opinion a telling manifestation of the oligopoly of Wall Street (which gives us things like 7% IPO fees with the spooky consistency of North Korean election results) which absent the pressure of competition, allowed the dominant underwriters to resist this change tooth and nail. It was even more glaringly apparent when these same US firms operating in Europe adopted e-bookbuilding as strongly as everyone else once it was obvious it was an evolutionary winner…
Where is Goldilocks when you need her? On the one hand you have high frequency and algorithmic trading dominating the world of listed companies with market shares often exceeding 50% of all volumes traded and with increasing instances of unstable trading and extreme volatility in liquidity as these machines enter and exit the market creating a complex, unstable chaotic system where long term investors who aren’t careful can literally be run over in both directions like Wile E. Coyote on an Arizona desert highway… On the other hand, in the world of private investments – in particular in the broad category known as venture capital – liquidity remains elusive with (too) many practitioners having a disfunctional and often irrational set of beliefs as to how and when liquidity is acceptable and when it is not, with the end result making naturally illiquid investments even more so. And yet, wouldn’t it be nice (for investors and companies) to have a long term capital market where liquidity was “just right?”
So what would just right liquidity look like? Can you have your cake (all the typically enormous strategic advantages that accrue to a private company) and eat it too (the advantages of being listed, afforded by having a periodic mark-to-market and the ability to use your equity as a real currency)? I think you (mostly) can and am very encouraged to see this sweet spot slowly emerging and gaining traction outside of a handful of what previously would have been considered exceptions to the rule. In my opinion, the answer (as I have mentioned before) lies in further developing secondary markets in private company equity.
The two most successful companies I have had the privilege of investing in – Markit and Betfair – despite being multi-billion dollar companies and market leaders, are still today private companies and have provided liquidity to investors, management and employee shareholders (in different ways) which has gone a long way to allowing them to remain private and reap the associated benefits. The flexibility of Facebook’s management to run their company for the long term optimal outcome has I suspect been a direct function of the liquidity that secondary investments (from DST) and a relatively active secondary market in Facebook shares on platforms like Second Market and SharesPost have provided to early investors and employees. And it’s not just about cashing out – at least half the value of these secondary markets comes from providing a credible mark-to-market and the reasonable expectation that – if needed – an investor could access liquidity. Perhaps paradoxically, with these two factors in hand, more often than not, investors will actually have a higher propensity to hold on too their investment, not lower.
Another benefit of secondary markets would be to improve the health of the overall venture investment ecosystem which while evolving in fits and starts, most recently with the rise and rise of “super-angels” and “seed funds” still mostly remains in the eyes of this industry outsider, static and prone to herding around the notion that one-size-fits-all in terms of capital structure and financing paradigms is somehow optimal and should not be questioned. In particular, I fail to understand why the received wisdom of the venture capital community seems firmly stuck on the concept of “nobody exits until everybody exits”. It’s a dumb concept and worse, quite frankly is at odds with the interests of the various investors and stakeholders in a private company, including later stage investors (aka mainstream venture capital funds.) I believe much of the angst surrounding seed stage investing and (traditional) venture capital investing, arises as a result of a dysfunctional transition mechanism. (ie There isn’t really one.)
What I would like to see – and quite frankly have never heard a good counter-argument against – is a more dynamic and flexible financing chain, one that pragmatically combines both primary and secondary elements. Practically speaking, what would this mean? At its simplest, it would mean that at any given funding round, the possibility of existing investors exiting part or all of their holding is considered objectively and without undue emotion. Having participated in many such transitions in companies going from “seed” funding to “series A”, or “series A” to “series B”, etc. the relationship between existing shareholders and the new shareholders is far to often one of conflict – to the extent that this is often seen as just the normal way of things – when there is no reason that this ever need be the case. Venture capital firms often talk of “needing” to invest a minimum amount of capital and/or “needing” to own a certain minimum stake in the companies they invest in. While I think the case is sometimes overstated, if you understand the dynamics of their business model, their attitude is easily understandable and basically rational. And yet, I have never yet seen a venture capital fund offer to buy-out the early stage investors in whole or in part when more often than not this would be an ideal outcome for everyone:
the company: not needing to raise more new capital than strictly necessary
the early stage investors: (whether professional angels or seed funds or friends and family) allowing them to reduce risk, recycle capital and retain focus on the market segment (early stage) they know best and which corresponds to their capital base
the venture capital funds: allowing them to simplify the capital structure, deploy more capital and ease negotiations
If this became the norm, I think it would drive a massive downstream benefit which would be to create a more dynamic, focused and intelligent early stage investment paradigm as investors in this ecosystem niche could really focus on funding two types of companies:
companies that have a plausible case to become successful but modestly sized businesses worth $10-40 million; and
companies that have a plausible case to become “VC fundable” where the goal is to exit in a series A or series B at $10-40 million
This would considerably improve both the availability but also the quality of early-stage capital as the risk / return dynamics would become much less random and the impact and velocity of the best investors in this space would increase considerably, providing more, cheaper and easier access to capital to entrepreneurs while at the same time providing a fantastic “farm-system” of talent and corporate development to later stage VC’s, perhaps even allowing (the best amongst) them to deploy their hundreds of millions or billions of capital efficiently as their ecological niche becomes better defined. I am absolutely convinced that this paradigm would create a much healthier, more vibrant capital market for innovation and disruption, improving returns for everyone in the ecosystem.
What I am not saying is that buying out seed investors would be appropriate in every situation. Nor that all seed investors would always be happy to sell all or even part of any individual investment. Nor that later stage investors should always look to buy out early stage investors. What I am saying is that this discussion should always be a part of the financing tool-kit, this option should always be on the table, and dismissed only when and where it is objectively inappropriate. Let’s get rid of the dogma and let markets work. Liquidity: not too much, not too little, let’s get it right!
You may have noticed that I haven’t posted much in the last couple months and given all the interesting things going on in the world it certainly wasn’t for lack of material. Breaking my arm obviously didn’t help increase my productivity (or make typing very easy) but it wasn’t the main reason for the silence. It’s much simpler than that: I was busy!
Busy investing in a whole bunch of super exciting and interesting new businesses. Busy working on the sale of ODL Group (where I was the lead independent non-executive director) to FXCM to create a true global leader in FX trading. Busy working with my partner Uday and FT Advisors on a number of interesting strategic advisory projects, in particular focused on the electronic and algorithmic trading space. Busy helping two of our portfolio companies raise follow-on financing. Busy working on our own corporate structure and capital raising where I hope to be able to communicate some exciting news in the not too distant future. Busy.
So what have we been investing in? Here is a quick rundown (in alphabetical order):
Babuki – 2008 seedcamp winner, launching soon (will update) with an innovative platform for social gaming
BankSimple – “an easy, intuitive, and social bank for people who appreciate simple online services. Unlike other banks, we don’t trap you with confusing products nor do we charge any hidden fees. No overdraft fees. We use sophisticated analytics to help you better manage your finances by providing you a individualized service, catered to your needs and goals.” Recently got some attention when they announced that Alex Payne of Twitter fame has joined as CTO. They also got a great write-up from @maxableson in the NY Observer.
Blueleaf – investment information management and planning software “to help people like you see all their savings and investment accounts in one place; understand their financial information more completely, more quickly; securely share information and collaborate with spouses, family or advisors; save their data, even if they change financial institutions; and maybe most importantly, help them stay financially safe and secure.”
Timetric – builds services to make sense of time-series statistics, based on the Timetric Platform: a proprietary service for publishing, analysing, and performing calculations on very large quantities of time-varying statistical data. Have a look at this neat little demo website they have built for tracking equity portfolios.
Metamarkets – provides global, real-time media price discovery by aggregating billions of electronic media transactions in order to deliver dynamic price data, proprietary price and volume aggregations, and comprehensive analytic media market views to sell-side media principals.
[not yet closed - will update soon]
Over the next few weeks or so, I plan to do a proper write-up on each of these businesses and the reasons we think they have bright prospects. So watch this space.
There’s nothing more valuable than an unmet need that is just becoming fixable. If you find something broken that you can fix for a lot of people, you’ve found a gold mine. As with an actual gold mine, you still have to work hard to get the gold out of it. But at least you know where the seam is, and that’s the hard part. - Paul Graham
In the latest of his series of great essays, Paul Graham makes the obvious – but all too often overlooked – point that one of the best ways to create value is by working to “fix things that seem broken.” He also highlights the fact that sometimes it pays to step back from your daily environment to get a clear picture of what is broken:
You may need to stand outside yourself a bit to see brokenness, because you tend to get used to it and take it for granted. You can be sure it’s there, though. There are always great ideas sitting right under our noses.
At the end of 2006, after a long, successful, and mostly exciting and enjoyable career in capital markets I took that step outside. And my suspicions became convictions. Finance seemed broken to me. And it bugged me. It still bugs me. It bugs me when super smart people (who aren’t financial or market professionals) resign themselves to accept crappy advice and ill-suited products and services when it comes to their finances. It bugs me that so many bright, energetic, ambitious people working within the financial services sector continue to be trapped in the status quo of 20th (even 19th) century business models, their talents misdirected when the alternative is so much more appealing.
And so I thought I should try to fix it. Not all of it. Not all at once. But more than just a single facet. I haven’t got it all figured out yet, but I think I’m headed in the right direction and most importantly I’ve learned more – about the industry, about people, about building value and about myself – in the past 3 years than in the 10 before combined. I’ve never worked harder and I’ve never had more fun. And I’ve met some pretty amazing people too.
A few days ago, Fred Wilson commenting on the (ridiculous) inclusion of venture capital in the financial stabiliy bill wrote this:
The only systemic risk the VC business is creating for the financial system is attempting to put the current one out of business by financing entrepreneurs with new ideas for banking, brokerage, insurance, and other financial services. I’m not joking about this. I believe entrepreneurs will use technology to reinvent the way financial services are provided to consumers this decade.
“Using technology to reinvent the way financial services are provided to consumers this decade.” Nice. In fact that is our elevator pitch. I just hope Fred doesn’t mind if we use it.
Now, though it maybe hard to predict what innovations PayPal’s platform will enable, it’s safe to say that the payment industry is going to change dramatically. As money becomes completely digitised, infinitely transferable, and friction-free, it will again revolutionise how we think about our economy.
The author talks excitedly about PayPal’s new open platform X.com and how it is poised to change the current payments landscape which continues to be dominated by the credit card companies. PayPal launched this new approach late last year with their first developers conference Innovate09. Here’s what PayPal President Scott Thompson had to say about the conference:
As you might imagine, given my views on both the enormous opportunity that exists to disrupt an increasingly anachronistic financial services industry and my enthusiasm for “platform-based” business models, it is quite satisfying to see someone like PayPal take on this opportunity in such an aggressive manner. Not only do they help to validate the opportunity – bringing both human and financial capital to bear – but they can capture the attention and imagination of a generation of engineers and entrepreneurs in a way that we simply could not (at least not yet), even if we had a very large amount of capital to deploy. And that can only be good news, except perhaps for the management and shareholders of dominant incumbents like Visa:
“What we witnessed was truly a perverse form of competition,” said Ronald Congemi, the former chief executive of Star Systems, one of the regional PIN-based networks that has struggled to compete with Visa. “They competed on the basis of raising prices. What other industry do you know that gets away with that?”
Of course payment networks are classic “two-sided” markets, with strong natural tendencies towards monopoly providers (due to strong network effects and high barriers to entry. Further the structure of these markets allows providers to levy charges on only one side of the market (merchants) while seemingly offering the other side a free or inexpensive service. Last fall The Economist explained why, in such a market, regulation is often ineffective and can often actually produce worse outcomes in some cases:
The case for tight regulation seems strong, at first glance. In rich countries, where paying by plastic is now commonplace, the firms that run card-payment systems look like other utilities, which have long been subject to price caps. Visa and MasterCard are associations run on behalf of their member banks. Competition officials are usually wary of such shared ventures but accept that it is more efficient for rival banks to band together in one network in order to process payments and settle accounts. A common fee structure stops members from abusing the rule that retailers must take all cards issued with the association’s brand. It also obviates the need for countless bilateral deals between thousands of banks. Even so, regulators still fret that banks might use their combined heft to overcharge.
They need to tread carefully. Judging how much credit-card firms ought to charge for their services is trickier even than setting the right price for water or energy supplies. That is because the payment-card system is a “two-sided” market. What sets this type of enterprise apart is that it caters to two distinct groups of customers and each sort benefits the more custom there is from the other sort. Consumers will sign up for a credit-card brand if it is widely accepted as a means of payment. Merchants will more willingly accept a card if lots of consumers use it.
In my opinion, the best way to ensure good value to all the participants in the payments value chain is to encourage and facilitate competition: new approaches, new ideas, new entrants. PayPal has long been the poster-child for “start-up” innovation in financial services, but had seemed to have lost its way in stuck in the corporate bureaucracy of eBay. It’s great to see them breaking free of that and striving to re-ignite their creative and entrepreneurial juices. (Although I still think they would probably be better off independent of eBay…even better, how about a merger of an independent PayPal and an independent AWS: now that is a stock I would love to own!)
For several years now, it has been dead obvious to me that new and exponentially improving information and communications technologies would create the foundation upon which bright, ambitious entrepreneurs would build new companies and business models that will disrupt the moribund incumbents and their 20th century business models. And that’s why I started Nauiokas Park. We’ve made some good decisions along the way, and we’ve learned a lot. But one thing we got spectacularly wrong was our naive belief that leading incumbents in the financial services sector would embrace our vision and our proposition as an opportunity to hedge the strategic risk of continuing to rely (exclusively) on their existing business models. That they would look at the management failures and massive value destruction suffered by the traditional media and telecommunications companies and look to deploy multiple strategies to mitigate the risk of being caught unawares in the same way. But it would seem that they are uninterested. A toxic cocktail of hubris, myopia, inertia and institutional politics seems too often to blind them to the risks posed to their continued hegemony. As if admitting Christmas exists – let alone voting for it – would make it’s inevitable arrival more likely.
Ten days ago, an irresponsible and unthinking young man crashed into me from behind at great speed while I was skiing with my children. The force of the impact broke two things: my right ski and the top of my right arm. There were multiple fractures and (the shoulder being full of many nerves, tendons, muscles) I was advised that I would need surgery to ensure proper healing and that I should entrust this only to an expert specialist surgeon. Fortunately, via my network I was able to identify just such a doctor quickly but it meant that my surgery could not be scheduled until Wednesday last week. I think it is fair to say that I totally underestimated the seriousness of the injury and surgery and somehow thought I’d be patched up and good to go in a day or so. Today is Tuesday and only now am I “back at my desk” feeling pretty good, although without the use of my right hand for typing. So, other than some limited iphone-based twitter and email scanning, a couple calls and starting some “to-do triage” over the last couple days, this totally random accident has cost me nine days “offline” (in the broader getting-things-done sense) and will continue to impact my productivity – in particular my ability to travel and type – for at least the next 4-6 weeks. While I am confident that I’ll be able to adapt somewhat (my left-hand only typing is already 5-10x faster than a couple days ago, although still not close to my usual 60+ wpm and I can now actually get the curser to the right spot in under a minute using a mouse), it would be ridiculous not to acknowledge this as a unwelcome setback.
But why am I explaining this here? And no, it is not to generate an outpouring of sympathy (which however I must acknowledge as very nice as I have been fortunate enough to have been reminded of over the past week.) No, there are effectively two distinct reasons I thought it would be worth telling this story.
The first is from a strictly practical standpoint: to get the word out to all the people I “work with” on a day-to-day basis without needing to write dozens or hundreds of emails (never much fun at the best of times but even less appealing with one-hand…) I suspect not all the people that I’d like to have this information are readers, and clearly for many of you this is probably unnecessary information, but while clearly not perfect, the broadcast mechanism of a blog I felt was the best option available to me. So for those of you waiting for an email or call to be returned, or an appointment to be confirmed, now you know what has happened and I would ask your indulgence and patience. If you have heard nothing back from me in the next few days or so, or if it is more urgent than that, please follow-up with a nudge. Otherwise, give me a couple weeks and I’m sure I can get back on top of things (at least as much as I ever do!)
The second reason is hopefully more interesting to a wider audience and is about addressing one of the risks that seems to me to be less discussed in the vibrant “start-up commons” that many other issues venture entrepreneurs and investors face. This is the risk to founders health from exogenous, unanticipated events.
In particular, I’m interested in risks not readily addressable by traditional key-man life insurance. This of course is a standard requirement when raising outside investment and insofar as it protects investor capital (if not their opportunity cost) from the worst-case result of a catastrophic injury or death of one or more of the founders (ie winding up of company), it probably doesn’t help in the more probable situation of a significant productivity loss due to severe illness or accidental injury. Thinking through our portfolio of early stage companies, I dare say none of them has thought much about this except for one, and if I am honest, this was only because we had to manage just such a risk in the early days of the company (which I’m happy to report was successfully done, helped of course by the individual’s recovery proceeding as expected.) If you are a start-up founder or investor, have you given this much thought? If so what sort of solutions or contingencies have you put in place to mitigate this risk? Are any insurance companies writing policies that pay out (to companies, quickly) in the case of non-critical short term health issues with key personnel? If so is the pricing reasonable?
I’ve obviously had a few days and a good reason to think about this, and just to be clear, have been considering the question in the first instance from the point of view of a founder. (For while we are also investors, my company is in fact a start-up and I am reliant upon it for my livelihood.) And in terms of protecting my family, I have life insurance, but this accident underlined that in the event I were temporarily incapacitated and unable to work, mitigating the financial risk arising is potentially much more problematic, and that this is a problem (most acutely) faced by start-ups and small businesses. Indeed, were I still working for an established (big) company or organization, I have a very nice letter from my doctor stating I cannot work for the next 4 weeks and so I would sit at home collecting my salary and healing. But even more importantly, the business of the company would go on (even if I were Steve Jobs); and while (one would hope that!) some opportunity cost would be incurred, the larger and more established the company or organization, the more marginal it would be. ie The problem (for founders and their investors) isn’t insuring the loss of a month’s salary/revenues/burn per se (which is I’m sure a tractable actuarial problem.) Rather, it is insuring the opportunity loss of a month of foregone productivity or progress. And because the “value” of this lost opportunity is subject to so many internal, external and temporal/situational variables unique to each founder/company pair, I suspect this is probably an uninsurable risk, at least in the sense of financial insurance. Indeed, I think the solution to mitigating this risk if one exists lies more in ‘operational engineering” admitting that in some cases even this will be impossible.
And so my (highly tentative) conclusions are that:
founders should probably think about a “Plan B” to manage their personal risk (eg this could be cash savings, support from family, returning to traditional employment, etc.)
investors need to consider the value of portfolio diversification in this context and perhaps, insofar as possible, think about what critical skills may be replaceable on a temporary basis should a founder be incapacitated for a few weeks or months and ideally build a network of people who have or have access to these skill sets; my thinking here is not to suggest that founders are replaceable but that it may in some cases be possible to soften the impact should the unexpected happen.
I would be very interested in the community’s thoughts on this and in particular whether they think it is a risk that can and should be acknowledged and managed in early-stage (and/or later-stage) companies, or if on the contrary they believe this is an intractable risk and so just needs to be “accepted” without wasting any time, energy or money trying to manage it.
So having spent 90 minutes on this post (sooo slow…) I better get down to work, and so while I’ve a dozen posts up my sling, I probably won’t be back here for a week or so as I work my way through a daunting (but mostly exciting) to do list. Oh, and for the next few weeks at least, you can just call me Lefty.
Two trading firms, one of them an established Wall Street player and the other a Midwest upstart, are each about to premiere a sophisticated new financial tool: a box-office futures exchange that would allow Hollywood studios and others to hedge against the box-office performance of movies, similar to the way farmers swap corn or wheat futures to protect themselves from crop failures.
The Cantor Exchange, formed by New York firm Cantor Fitzgerald and set to launch in April, last week demonstrated its system to 90 Hollywood executives in a packed Century City hotel conference room….
…On Wednesday, Indiana company Veriana Networks, which says its management includes “veterans of the Chicago exchange community,” unveiled the Trend Exchange, its own rival futures exchange for box-office receipts.
These are exactly the kind of novel risk management marketplaces that will continue to emerge over the next 5 to 10 years as technology enables robust, easy and cost-effective trading and settlement mechanisms and data (which is the raw material of any exchange or risk management toolkit) continues to grow in size, richness and availability across every sector of the economy. Indeed the greatest impediment to the development of such markets is cultural: there is still an irrational, sometime hysterical, aversion to any risk management tool that is non-traditional and can be characterized as gambling. Of course gambling, trading and hedging are indistinguishable in practice and can only be differentiated in context, and really only represent differences in intent. As such, it is very difficult to proscribe one while allowing the other(s). There are however reasonably good, tried and tested regulatory frameworks that have been developed over decades to manage unhealthy practices (insider trading, market abuse, etc.) in traded markets for outcomes and commodities. Using these, regulators should be happy to quickly approve as many new marketplaces or exchanges as creative entrepreneurs and traders invent and let a thousand flowers bloom. I don’t think it is for the regulators to second-guess who might be interested in trading such markets and why, as long as the market rules and framework are robust, transparent and participants are swiftly held accountable for any abusive behavior.
But that certainly isn’t the way the establishment sees things and even those that are developing new markets often see their market as an exceptional addition to the risk management landscape rather than a specific example of a more general case. (Although to be fair this may be simply a tactic to curry favor with the forces defending the status quo in order not to appear to be too heretical and so smooth approval for their specific new initiative.)
“The day that a widow or orphan bets against ‘Finding Nemo 3′ — that’s not a good day,” said Rob Swagger, Veriana’s chief executive.
Why? Why shouldn’t anyone be able to put their knowledge and insights to work to make a return. Why is it ok for a ‘widow or orphan’ to bet on GE’s future performance (by buying or selling their shares) but not to bet on the potential return of a film? It simply doesn’t make sense. Or the view that certain risks or outcomes are worthy of being traded and managed but not others?
Government authorities have generally approved only those futures exchanges that allow for the redistribution of a preexisting risk. Sports betting is not approved because, unlike a farmer selling a futures contract to offset losses from crop failure, neither party involved in the wager has an economic interest in the underlying event.
This statement is of course patently ridiculous. Many, many agricultural risk contracts are traded amongst principals who are neither producers nor end consumers, and to say that there is no ‘real world’ economic risks that could be managed via sports trading is just silly given that sports is an enormous, global business with hundreds of billions of dollars of capital at risk. And if that weren’t enough, it is happening anyways, with admittedly high risks of fraud and abuse. Wouldn’t it make more sense (in the context of protecting vulnerable market participants) to encourage regulated, robust, well monitored marketplaces rather than cling to the current Potemkin-esque prohibition? (Disclosure: I am a shareholder in Betfair.)
In any event, I can only endorse Cantor’s vision of creating a new, more vibrant and useful market for managing risk and structuring finance in the entertainment industry:
Now Cantor hopes for its exchange to be the first of many complex financing products for the entertainment industry. In one of the more ambitious plans, Jaycobs wants to team with filmmakers to create something like an initial public offering of stock in a specific film, staking out a potential new way to finance production.
And I hope they (and Trend Exchange,) working along side the CFTC are able to quickly illustrate that well-built and well-regulated marketplaces can mitigate the potential dangers while at the same time providing a powerful and useful set of tools for managing risk and generating returns. Perhaps this will help pry open the door to seeing more and more outcome markets develop of the course of the next several years.
I’m not sure what the venture community makes of Right Side Capital Management, but I think their novel approach to early stage investing is really interesting:
Yes, we do love fledgling startups. They may not have finished products, marquis customers, or proven markets. But every one has “Black Swan” potential.
Given the opportunity they represent, seed-stage startups are badly underserved. The chances of finding funding are so low that many qualified entrepreneurs sit on the sidelines. It takes so long to put together a decent-sized angel round that many promising companies miss their market window. The transaction costs are so high that a good chunk of investment capital evaporates instantly.
We’re going to change that. We’re planning to fund 100-200 seed-stage startups each year and give founders a yes-no decision in two weeks. It’s a win-win. Lots of entrepreneurs get a chance to innovate. We get a well-diversified portfolio.
I think this approach is very clever and (in a slightly different context) in fact a couple years ago worked on a business model focused on improving angel funding process / environment (for both investors and entrepreneurs) that very much relied on a similar systemization of process. While I’m not sure we are ready for a fully algorithmic early stage investment process (black box VC anyone?), it seems clear that there is certainly a lot of room for a more robust (technology-enabled, data-driven) process, lowering costs and improving efficiency. I hope RSCM succeeds and in so doing helps move the market towards this vision which I think would be a win for both investors and entrepreneurs.
I particularly like the way they have clearly articulated one of the key factors involved in early stage investing – chance – and how their high-volume, process-driven approach addresses this issue head-on and seeks to mitigate the impact of luck (good or bad) on portfolio returns:
However, we also understand that the probability of a particular young startup succeeding is relatively small. Many things are beyond its control. Many things can change. Many things have to go right. Probability compounds and there are literally thousands of factors that can significantly affect a young startup. So there’s a tremendous amount of uncertainty. We do not believe anyone has a model with much skill in picking winners at the seed stage. Therefore, the only reasonable strategy is to diversify away the idiosyncratic risk as much as possible by constructing as large a portfolio as is practical.
No one can claim to ever be able to fully remove risk from any process, but by bringing talent and a deliberate process to bear, I do believe one can improve the odds of any given outcome considerably. A top professional golfer cannot guarantee a hole-in-one, and indeed it is possible that a 36 handicap weekend warrior could get one. Black swans etc. But if the competition consists of hitting 100 balls to a par 3 green and scoring 10,000 points for a hole in one, 100 points for any ball within 3 feet and 10 points for any ball on the green, I know I’d much rather back the professional golfer, even though there is a non-zero chance that the hacker could get lucky and win. I think venture – and especially early stage – investing is similar. I can’t guarantee any investor that I will get a hole-in-one. But I think I can make a credible case that most of the investments I make will be ‘on the green’ and a fair number will be ‘inside the leather.’ It seems that RSCM have taken this view and put it explicitly at the heart of their approach.
However, I would be curious as to the reaction of their potential investors/LPs to this kind of approach. It is entirely anecdotal and quite possibly an unrepresentative sample, but we have found most investors to be very cautious with respect to any new approach and/or structure, preferring standardized and ‘traditional’ ways of doing business with innovation a domain to be restricted to the companies we invest in. This of course may be particular to our circumstances, but given the extremely high homogeneity in fund structures and investing approaches we have observed across the venture capital (and private equity) universe, it would indeed seem that limited partners have little or no appetite for (as RSCM puts it) “innovation in the business of innovation.”
So if there are any LPs out there reading, I would encourage you to comment on both RSCM’s model specifically, and especially on innovation in fund structures and/or investment methodologies more generally.
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Ten days ago, an irresponsible and unthinking young man crashed into me from behind at great speed while I was skiing with my children. The force of the impact broke two things: my right ski and the top of my right arm. There were multiple fractures and (the shoulder being full of many nerves, tendons, muscles) I was advised that I would need surgery to ensure proper healing and that I should entrust this only to an expert specialist surgeon. Fortunately, via my network I was able to identify just such a doctor quickly but it meant that my surgery could not be scheduled until Wednesday last week. I think it is fair to say that I totally underestimated the seriousness of the injury and surgery and somehow thought I’d be patched up and good to go in a day or so. Today is Tuesday and only now am I “back at my desk” feeling pretty good, although without the use of my right hand for typing. So, other than some limited iphone-based twitter and email scanning, a couple calls and starting some “to-do triage” over the last couple days, this totally random accident has cost me nine days “offline” (in the broader getting-things-done sense) and will continue to impact my productivity – in particular my ability to travel and type – for at least the next 4-6 weeks. While I am confident that I’ll be able to adapt somewhat (my left-hand only typing is already 5-10x faster than a couple days ago, although still not close to my usual 60+ wpm and I can now actually get the curser to the right spot in under a minute using a mouse), it would be ridiculous not to acknowledge this as a unwelcome setback.
(which however I must acknowledge as very nice as I have been fortunate enough to have been reminded of over the past week.) No, there are effectively two distinct reasons I thought it would be worth telling this story. ![Reblog this post [with Zemanta]](http://img.zemanta.com/reblog_c.png?x-id=9b14e83a-b3f0-451f-90b7-aefce4fc293a)
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