Articles filed under 'Private Equity & Venture Capital'
When we set out to create Anthemis Group, we thought long and hard about how it should be structured.
We wanted a structure that would:
- optimally support our core mission to build the leading “digitally native” diversified financial services group of the 21st century
- fundamentally and structurally align our key stakeholders: investors, management, employees and our portfolio companies and their founders
- create transparent economics that are clearly driven by long term wealth creation through capital growth
- be as simple as possible while remaining operationally and tax efficient
We wanted a structure that would avoid:
- misaligned economics – in particular any structure which would incent management to raise capital without regard to cost; we want to be in the business of investing and growing capital not collecting it
- misaligned horizons- in particular having our investment decisions driven by tactical (time-driven) rather than fundamental considerations; the tail should not wag the dog
- undue complexity – in particular where it might lead to reduced transparency or fundamentally drive management or investment decisions; as simple as possible but no simpler
And so we very deliberately – against the grain of many (smart) people’s advice1 – decided to set Anthemis up as a company, or more specifically as a group of companies with a simple holding company at the top of the group structure. In order to give you some insight into why we made this choice, I’ve tried to distill what we believe to be the key advantages of this structure in the context of our business model, vision and goals:
We have one clear, measurable and transparent objective: grow the value of Anthemis shares over the medium to long term. All of our management decisions – which can essentially be distilled into allocations of human and financial capital and assessing the opportunity costs of both – are guided by our best judgement as to how these choices will affect the long term value of our shares. We get this right and everyone is happy. We win (or lose) together with our people, our shareholders and ultimately our portfolio companies and their founders.2
All investors are invested in the group’s parent company: Anthemis Group SA, a Luxembourg Societe Anonyme. We have only three classes of shares: preferred (with a simple 1x liquidation preference), common (essentially arising from the exercise of employee performance options) and founder shares (which are economically identical to common shares but carry certain limited governance rights and more onerous vesting and transfer provisions.) Investors and employees don’t need an advanced degree in financial modeling in order to understand the value or performance of their holdings. Beneath the parent company we have a small number of both operating and holding entities all of which are 100% owned by the Group, the corporate form and domicile of these entities has been chosen to ensure a tax efficient and compliant structure that is also cost effective to run. It is exceedingly simple to understand which we believe has its own value.
We have an enormous opportunity in front of us, one which requires our full attention and all our energies. Opacity is a tax on efficiency and productivity. It drains your mental energy. It increases entropy. Transparency sets you free. If nothing else it means that you never have to remember what you said to whom when. More importantly it builds trust which is the currency that fuels networks and ecosystems. Of course it is much easier to be transparent when your structure is simple and aligned across stakeholders. Paraphrasing Warren Buffett, “our guideline is to tell our stakeholders the business facts that we would want to know if our positions were reversedâ€¦and we believe candor benefits us as managers: the CEO who misleads others in public may eventually mislead himself in private.”
Building great businesses takes time. Typically at least 7-10 years in our opinion, sometimes longer. And having invested in and built a great business, why would you want to sell it? Or more precisely it would seem crazy to have to sell it. And yet that is exactly the constraints faced by traditional GP/LP venture funds. Sure a GP can ask for an extension, but that doesn’t change the fundamental truth that irrespective of circumstances, they have an obligation to exit their investments. Aside from the misalignment of fund terms with optimal venture capital investment horizons (which, to be fair, could to a largely be remedied if fund lives were 15 or 20 years rather than 10), the other disadvantage of being structurally forced into shorter, time-limited investment processes is that one inevitably risks being seduced by the siren call of high IRRs to the detriment of building real, tangible long term wealth which ultimately arises from actual cash on cash returns.
An evergreen – ie equity – capital structure is the simplest, most elegant solution. We also believe in robust and conservative balance sheet management: to use the trader’s vernacular, we believe in running a matched book. Equity financed with equity. If we do our job successfully, the last thing investors should want is to be given their capital back before they want or need it. If we are successful, there will be any number of ways to create liquidity event(s) as and when required by our investors. If on the other hand we are unsuccessful, quite frankly the structure won’t make a damn bit of difference to our investors’ outcomes. In fact they may well be better off holding corporate equity rather than distressed fund units, but almost certainly they would be no worse off.
Broken business models are the new black
Last week, the Kauffman Foundation published a very comprehensive and well written report concluding that “the Limited Partner (LP) investment model is broken” as “too many LPs invest too much capital in underperforming VC funds and on misaligned terms.”
There are more than simply structural differences between Anthemis and a venture capital or private equity fund; the most important of these is our ambition to build a coherent yet diversified group of companies that is perennial. This means that our investments (and eventual disposals) are framed in the context of optimizing our business portfolio and overall return on invested capital and are considered through a lens of corporate development rather than simply as individual financial investments. The fact that our current investments (we currently have 20 companies in our portfolio) have been entirely concentrated on “venture” stage companies reflects quite simply our thesis that the global financial services sector is at the early stages of what we believe will be a secular transformation of the industry as “industrial age” business models are disrupted and ultimately replaced by “information age” or as we like to call them “digitally native” business models.
Over the next 10-20 years, our plan is to initiate, grow and consolidate our positions in the companies that emerge as leaders in this new economy. At the same time we plan to continue to make investments in disruptive startups emerging on the “innovation frontier” in order to maintain a vibrant pipeline of emergent technologies and business models in order to retain our immunization to the innovator’s dilemma. We believe that the optimal organizational paradigm of the information age will be predicated on networks, not hierarchies and have crafted our approach to building the leading financial services group of the 21st century to be inherently aligned with this hypothesis. Our vision is to build Anthemis into a strong but loosely-coupled network of complementary businesses focused on financial services and marketplaces; not to build a monolithic, hierarchical conglomerate. We never want to become too big to fail, our clear aim is to become too resilient to fail.
Although our investment thesis is fundamentally different, from a structural or even philosophical point of view our approach is very much inspired by Berkshire Hathaway. (Spookily, upon founding Anthemis, Uday and I happened to be very close to the same ages respectively as Warren Buffet and Charlie Munger when they “founded” Berkshire Hathaway in 1965. Here’s hoping history repeats!) As an aside, Henry Kravis once called Berkshire Hathaway “the perfect private equity model”, though why KKR didn’t or hasn’t adopted a similar structure is interesting. (One wonders if it isn’t as a result of the relative risk/reward (fee-driven) profile for the GP in a traditional private equity structure vs. the (equity-driven profile) of a founder/manager in corporate holding structureâ€¦) Other examples of thematically or industry focused groups from whom we draw inspiration are companies like LVMH or Richemont (luxury and branded goods) or Naspers and DST (media and internet) but ultimately we have the sense that what we are seeking to build is somewhat unique, something new. An evolution in corporate organizational structure which is adapted to the emerging social and economic landscape of the global information economy.
(excerpt from LVMH Group Mission:) The Group’s organizational structure is decentralized, which fosters efficiency, productivity, and creativity. This type of organization is highly motivating and dynamic. It encourages individual initiative and offers real responsibilities – sometimes early on in one’s career. It requires highly entrepreneurial executive teams in each company.
For both Anthemis investors and for the companies in which we invest, our focus and approach provides an interesting and complementary alternative to traditional venture capital funds. Although it would be naive to pretend there is no competitive overlap, our conviction (confirmed by our experience to date) is that we are in fact a positive new entrant in the venture ecosystem that complements rather than competes against more traditional venture investors. Not “either/or” but “and”. For the startups in which we invest, we know that building an investor syndicate of diverse and complementary talents which includes the networks and company building skills that the best VC partnerships bring to the table is the best way to ensure their chances of success. Our portfolio companies are much stronger for being able to combine our (sector-focused) talents and resources with those of leading VC firms such as Atlas Venture, Bessemer Venture Partners, IA Ventures and others too numerous to mention. And it is equally clear to us that Anthemis is strengthened by the continuous learning and exchanging of ideas that comes with having the privilege of working alongside so many smart and seasoned partners and associates of these VC firms.
For our investors, we offer a unique and efficient way to gain intelligent exposure to the future of financial services. And while clearly there are some similarities in our risk/return profile with that of a traditional venture fund (given that a very significant proportion of our balance sheet is invested in early and venture stage companies), we are nonetheless not strictly speaking substitutable (in the way say traditional “bluechip” generalist VCs might be.) And as we grow – just as for the startups in which we invest – our risk profile will naturally evolve. Indeed one could think of Anthemis as a financial services “meta-startup”. That said, when considering Anthemis I suspect that many of our existing and potential future investors would characterize Anthemis as a direct venture-stage investment, with any allocation coming from within their venture capital (or private equity) bucket. As such, I thought it would be interesting to examine how Anthemis might stack up in the eyes of an investor in the context of the five recommendations of the Kauffman report.
(1) Abolish VC mandates
Not sure if this is directly relevant to Anthemis. However we would agree that anything that encourages a return to substance over form in the context of LP asset allocation is a good thing. A private equity investment process that focuses more on the “what” rather than the “how” strikes us as being more sensible given the heterogeneity and illiquidity of these types of assets.
(2) Reject the Assumption of a J-curve
Traditional venture capital theory (useful it seems when justifying reporting opaqueness!) states that investments in startups (and thus portfolios of startups in a particular vintage fund) go through a cycle by which their valuations initially decline before later increasing in the goodness of time as the big winners in the portfolio emerge (and are fed more capital) and the losers fall away (with relatively limited capital having been invested.) Kauffman however found that this theory while it sounds good, isn’t borne out by reality; rather most funds experience an “n-curve” whereby valuations increase substantially in the first 2-3 years (driven by follow-on venture financings at higher and higher – but generally unrealizable and almost always unrealized – valuations), only then to deteriorate over the remaining life of the fund. (ie Big winners often don’t emergeâ€¦) Unsurprisingly, they also found that these increases in (paper) value topped out at almost exactly the same time that GPs sought to raise their next fund, producing a flattering backdrop upon which their LPs could tick the track record/historical returns box. The reader can draw their own conclusions, but Kauffman concludes that “too many fund managers focus on the front end of a fund’s performance period because that performance drives a successful fundraising outcome in subsequent funds.”
Investors in Anthemis don’t have to worry as to whether there is a J-curve, an n-curve or an “any-other-letter”-curveâ€¦as they are owners of preferred equity in Anthemis. We don’t raise subsequent funds. The Anthemis founders and management are significant shareholders whose performance compensation is largely equity-driven. Any time Anthemis raises new equity capital (our analog to raising a new fund), both our focus and the new investor’s focus is on future expected returns on this capital. Full stop. If we go to raise new capital and investors think the share price on offer is too high (or at least too high to offer them the risk-adjusted returns they expect), they won’t invest. If the Anthemis Board thinks the share price offered is unattractively low (insofar as the cost of capital exceeds the company’s expectations as to it’s projected risk-adjusted returns and/or those available from new investments), it won’t issue.
Every smart entrepreneur and venture capitalist understands the intrinsic tension between capital and dilution which acts as a powerful aligner of interests. We simply embrace this dynamic, aligning our returns to those of our investors and removing path dependency and our ability to arbitrage the structure at the expense of our investors.
(3) Eliminate the Black Box of VC Firm Economics
I must admit that before reading the Kauffman report, I didn’t realize how little information VCs provide to their LPs. It’s pretty ironic given that most VCs spend more time negotiating (and are more dogmatic about) the nuances of control and information rights in the companies in which they invest than pretty much anything else, including valuation. The report highlights that “LPs seem to lack the conviction to require the information from GPs in the same way the GPs themselves require it” and apparently don’t use the leverage that they potentially have to force the issue, according to one GP quoted in the report “LPs never walk away.” Sure. Um, that sounds like a robust and healthy investment process. Yikes. But the boxes are ticked and the forms all filled in nicelyâ€¦and so everyone’s happy.
Another perceived top-tier GP agreed with our view about the importance of transparent partnership economics and he admitted “no good answer” as to why LPs couldn’t receive the same information about his fund, except that the information is “never shared.”
Ok so you can get away with it, fine, but why? Why not be transparent? It sounds like a bunch of derivatives bankers that won’t share the model because they’re afraid the client will find out just how big their margin is and “won’t understand” all the costs (systems, people, capital – immediate and contingent) that this gross margin needs to support. (Irony alert: of course these same bankers usually hold up this gross margin to their managers as profit, blithely ignoring these same items in the pursuit of a “fair bonus”â€¦) Imagine Joe Entrepreneur saying to Jim VC: “Just write the check and trust me. It’s complicated, I don’t want to cause you any unnecessary anxiety or have you misunderstand the numbers. That would be distracting. I’ll let you know when I need more. Thanks.” Come to think of it Jack Dorsey could probably get folks signed up on those termsâ€¦
So Anthemis is not a black box. We treat our investors like any startup would treat their VC investors. We have certain information and governance rights written into our articles and in general we respect and are open with our investors, doing our best to keep them informed and making ourselves available when they have ideas or questions they would like to discuss. We have audited financial accounts, a clear remuneration policy (overseen and approved by the Board including at least one Investor director) and quite frankly a pretty transparent and straightforward approach to investor relations. We can’t imagine having a conflictual, non-trusting relationship with our investors. What we are trying to build is hard enough as it is, we need our investors to be on board: not just financially, but intellectually and emotionally.
And so I hope Warren doesn’t mind if we adopt Berkshire Hathaway’s first Owner’s Manual principle as our own:
Although our form is corporate, our attitude is partnership. Udayan, Nadeem and I think of our shareholders as owner-partners, and of ourselves as managing partners. (Because of the size of our shareholdings we are also, for the moment and for better or worse, controlling partners.) We do not view the company itself as the ultimate owner of our business assets but instead view the company as a conduit through which our shareholders own the assets.
(4) Pay for Performance
Our first hand understanding of how this principle was being misapplied in much of mainstream finance and asset management was yet another proof point for our thesis that financial services business models were ripe for disruption. It is the shield the industry wraps itself in: “we may be paid well, but we are a meritocracy and our pay is justified by our performance.” This may have been true once – and in some firms in some activities it probably remains true today – but these are too often the exceptions not the rule. It’s a whole other essay as to how and why this is and how it came to be so, but I’ll spare you the details and jump straight to the punch line: too many compensation models are structurally biased to favor human over financial capital and worse, compound this bias with path-dependent outcomes that reinforce the skew, sometimes dramatically so.
The standard 2 and 20 fund compensation paradigm is one of these. There is nothing fundamentally wrong with the principal behind it – you get a management fee to cover your overheads and a performance kicker if you generate returns (even better if there is a hurdle rate which should be based on the risk-free return plus possibly some margin for the extra risk or illiquidity depending on the strategy.) And frankly, this model can and does work, especially when the managers have a substantial stake in the fund (both in absolute terms and in terms of a % of their net worth) and when the fund has performance high-water marks and/or hurdle rates. Good examples of this model working are often found in the hedge fund world, where principals often own much or even most of the fund and their holdings represent a very substantial proportion of their total net worth.
In cases where these conditions aren’t met it often doesn’t work out so well. The fixed percentage management fee acts as an opiate, driving managers over time to focus their energies on asset gathering (not management.) The temptation to increase AUM to the largest (credible) size is strong as doing so essentially gives the managers a free upside performance option as the management fee alone becomes enough to pay themselves handsomely. Heads I win, tails you lose.3 This pathology is bad in any asset management context, but is particularly toxic with respect to venture capital given that it is an strategy that involves investing in a limited number of essentially illiquid securities.
If you are a macro hedge fund investing in FX and interest rates, the fact that you are managing $100mn or $100bn possibly doesn’t matter (especially if a big chunk of the capital is your own.) If you are investing in venture – or for that matter small cap public equities – a strategy that is highly successful with $100mn of capital can be a struggle to execute when you have $1bn or more to play withâ€¦) Unsurprisingly you often see some of the best VCs (who have easy access to capital) drift towards growth/private equity strategies where they can intelligently deploy larger sums. Done well this can be a good strategy (for all) but still we wonder why LPs aren’t more flexible and proactive in negotiating more tailored fee structures, either on a per fund and/or per firm basis.
In this context, our relatively simple, transparent “corporate” approach to compensation is an interesting alternative – it aligns management (who are also significant investors) with outside investors under all circumstances. First, not only is there no incentive for management to raise capital (grow assets) for the sake of it, there is actually a strong disincentive to do so: more capital means dilution. It has a cost. Raising capital is only interesting at a price that allows Anthemis to improve the risk adjusted returns of its existing and potential future portfolio of businesses. If the cost of raising equity is too high (ie the price of our shares is too low), it is financially more attractive for Anthemis (and our existing shareholders) not to raise more funds and to simply manage our existing portfolio of assets. To be clear – especially given the nature of our assets – I’m not suggesting that it is possible to create a spreadsheet that will spit out a definitive share price at which we should issue or not – there are too many subjective and uncertain inputs and pricing the opportunity cost of capital (which is essentially what I’m talking about) is as much art as science, especially at this stage of our development.
But what is clear – and structurally friendly to shareholders – is that there is symmetric risk and reward for management when raising capital. Just as there is for the founders of companies that VCs invest in everyday. You don’t see Jane Entrepreneur raising $100mn on a $1mn pre-money because she could then afford (to pay herself) a big salary; rather she is going to look first at what is the minimum amount (including a margin of safety) of capital needed to achieve her key value-creating milestones (while paying herself a reasonable salary.) If the price offered is unattractive, she’ll probably err on the side of raising less capital; if the price offered is generous, she’ll probably err on the side of raising a bit more. Simple. Valuation matters. Dilution matters. And most importantly, what is good for Jane in this context is (almost) always good for her existing investors. Alignment.
So how do the management and employees at Anthemis get paid? Basically there are three components, all of which are easy to understand and ultimately transparent to our investors:
- Baseline: We pay our people competitive salaries and annual bonuses based on their experience and market value; this gives us some flexibility and resilience with respect to managing operating cash-flow while allowing us to attract excellent people who don’t have to be independently wealthy to finance their employment with us. Note that a very significant part of our overhead costs including salaries and bonuses are actually financed by our successful advisory businesses which are profitable on a stand-alone basis. These businesses then give a decent return on capital to the group while more importantly enabling significant operating leverage vis-a-vis our investing activities. Under a traditional GP/LP structure, given the size of our balance sheet, we would currently only be able to align a small fraction of our professional resources to support our principal investment activities. (And we would not be able to leverage the extremely valuable strategic and informational advantage arising.)
- Performance bonuses (cash): With respect to our advisory businesses, insofar as our operating revenues permit, we accrue a performance bonus pool. The size of this pool depends on achieving a certain net operating margin target as set and is agreed by the board.
- Long term incentive plan (equity): Each time we raise new equity capital, we create an option pool equivalent to 20% of the amount raised; these are options on common shares and have an exercise price equal to the price paid by investors in that round and are subject to standard vesting provisions. The options are then allocated to staff over the expected deployment period of the capital raised, based on a number of criteria (skewed towards their respective contributions to the development and performance of our portfolio participations) – again all agreed by the board. Some are also held back in reserve for new hires and exceptional performance rewards. In our opinion, this option structure offers a competitive performance incentive to Anthemis management and employees with a payout profile that does a much better job (than traditional GP carry structures) of aligning the interests of management and investors. Unless we increase their value and create liquidity in our shares, we don’t get paid.
(5) Measure VC Fund Performance Using a Public Market Equivalent (PME)
Earlier I mentioned that we were inspired by Berkshire Hathaway; one of the elements of their approach that we most admire is their very simple but obviously relevant approach to creating value4:
Our long-term economic goal is to maximize Berkshireâ€™s average annual rate of gain in intrinsic business value on a per-share basis. We do not measure the economic significance or performance of Berkshire by its size; we measure by per-share progress.
Intrinsic value is formed by three components: the value of investments, the value and growth of operating earnings and a third, more subjective element Buffett calls the â€œwhat-will-they-do-with-the-moneyâ€ factor. In other words the efficiency with which management deploys cash (from retained earnings and new capital raised) in the future. This last factor unfortunately for those who love algorithms is extremely important to the determination of intrinsic value and yet unmeasurable, it’s a judgement call. As an imperfect proxy to intrinsic value, Berkshire Hathaway tracks the per share book value and it’s performance vs both the S&P500 and the S&P Property & Casualty Insurance indices, believing that over the long term this measure at least gives a reasonable indication (although understates) the change in intrinsic value of the business.
Obviously we are not Berkshire Hathaway and so it would not (yet) be meaningful for us to simply take an identical approach to reporting, but we are adopting the same intrinsic value-based approach to evaluating and analyzing our performance and valuation. And once we have enough data to be meaningful, we will certainly look to track and publish (at least to our investors) a similar proxy metric that will allow our investors to compare our performance to the relevant benchmark(s).
The Kauffman Foundation in their report suggests that the Russell 2000 is an appropriate benchmark against which to measure generic US venture capital returns. Given that we invest globally and predominately in financial services and related businesses, I suspect we will need to look at other potential benchmarks and/or perhaps a mix of 3 or 4 different indices. In the past two years since creating Anthemis, the S&P500 is up c. 11% and the MSCI World Financials index is down c. 10%, I’m happy to report that so far we’re doing better than bothâ€¦ As an aside, if there are any index geeks out there reading this who have suggestions as to which index or indices would be the most appropriate benchmark for Anthemis, I’d be happy to hear your thoughts.
For most of my career I worked in capital markets and investment banking and mostly found it to be an incredibly stimulating environment and felt privileged to work every day alongside so many smart and ambitious people. I was particularly fortunate to have worked in fixed income at Paribas for most of the 90’s where I serendipitously found myself at the heart of the birth of the Euro bond markets, with the opportunity to participate directly in building new markets, products and businesses. And once the Euro came in to being, I naturally looked for the next big thing to build, the next big innovation, only to realize (slowly, over the course of several years) that the Euro project truly was exceptional in every sense of the word and that – like most big successful industries – there was actually very little interest in change or disruptive innovation. That “if it ain’t broke, don’t fix it” was the overriding philosophy. (Actually it turns out to be worse, “even if it is broke, don’t fix it”â€¦)
It is difficult to get a man to understand something, when his salary depends upon his not understanding it. – Upton Sinclair
And so I left. And when I immersed myself in the world of startups and venture capital, I was very excited to be leaving this mentality behind – after all venture was all about the new new thing, right? And although I found this to be true of the founders and companies financed by venture capital, and just as in investment banking was thrilled to find myself amongst another group of incredibly smart, ambitious and (new!) passionate people, I was surprised to find this didn’t extend to how VC partners thought about their own business and business models. In this respect, they were collectively just like the bankers I had left behind. (And given the context, this was even more cognitively unsettlingâ€¦)
Uday and I (and our newest partner Nadeem) set up Anthemis because we were convinced that a very big opportunity exists to do things differently in finance. And while it wasn’t at the core of our mission, if you think about it venture capital itself is part of the financial services pantheon and without having set out deliberately to do so, perhaps we will play a small role in catalyzing disruptive change here as well if our model proves to be successful. Meta-disruption anyone?
Thinking about it, I suspect our model could work for other industries and sectors – especially for those where there are strong network effects and where companies and businesses form an interdependent ecosystem and/or value chain. For example an Anthemis for retailing? health? energy? As an investor, I would certainly be interested in building a portfolio of these. Think of it as the the equivalent of sector-focused ETFs but for disruptive, emerging growth companies. Until/unless they were listed, it would be hard to short these companies so it would be impossible to run a balanced long/short strategy in both directions. But a more adventurous or aggressive investor could at least express an even more aggressive view on industry disruption by shorting an index of the incumbents in each sector (against a long position in the innovation holdcos.)5
What is clear is that change is coming to the world of private capital markets, whether it is sector-focused holding companies like Anthemis, platforms like AngelList, CapLinked or even Kickstarter and others, private company exchanges like Second Market and SharesPost, new approaches to the VC model like A16Z,Â Y Combinator, 500 Startups and many other ideas I’m sure that will emerge. Given our nature, I guess it’s not too surprising to find ourselves disrupting on this dimension too! Interesting times indeed. Stay hungry. Stay foolish.
1 The consensus advice was not to “rock the boat” by doing anything that might be perceived by potential investors as innovative or different. It’s not that we didn’t believe the advice – indeed we were certain that in the case of the vast majority of traditional private equity LPs, this was going to be true. (And has been confirmed by the Kauffman report who note that “GPs indicated that they and their partners had discussed offering alternative structures and received very negative reactions.”) So are we stupid? Well I hope not. Our decision to ignore the advice to pursue a traditional venture capital LP/GP structure was based essentially on four points, in order of importance:
- conviction: a fund structure fundamentally did not correspond to our vision, objectives and business model and would have forced us to make material comprises in all three which we were unwilling to do
- ethics: having worked in investment banking and capital markets for many years, we had a clear and deep understanding of the traditional incentive models in the asset allocation and management value chain and we believed that in many cases these were fundamentally broken, causing (mostly avoidable) misalignments of interests with often toxic outcomes; we did not want to be a party to this – we wanted Anthemis to have a fully transparent and aligned structure
- strategic: we wanted our shareholders to deeply understand and endorse our vision, to become truly our partners for the long term and be able to weather the good and the bad and intelligently hold us to account because they get what we are building and believe in the opportunity; it may sound crazy (for someone who wants to raise capital) but by making it harder for investors with a “box-ticking” or “herd-following” mentality to invest, we felt this would help us ensure that those that did were both smart and aligned with us as founders
- pragmatism (or cynicism!): we believed that even with a plain-vanilla, consensus structure, we would struggle to tick all the boxes of a traditional LP who would rather invest in the 4th fund of a serially underperforming VC fund or even the first fund of a GP with years of junior experience at an established VC, than in a team of seasoned operating professionals with a clear vision, who’s track record of success wouldn’t however fit neatly into their approval grid; we weren’t IBM and we figured they probably weren’t going to risk getting fired by investing in us
2 There are two main ways in which our performance can have a positive effect on our (minority-held) portfolio companies:
- if our performance is good and our share price is strong, this gives Anthemis (greater) access to (relatively) cheaper capital which will allow us greater scope to support the growth ambitions of our portfolio companies as opportunities arise; their success drives our success which in turn helps us be an even better, stronger strategic shareholder to them
- if our shares perform strongly, this creates an interesting currency that we can offer to the founders and executives of our portfolio companies, allowing them a mutually attractive third alternative to hold or sell if and when the day comes when they would like or need to reduce their holding in their company; we hope and expect that this will create a unique and powerful incentive that allows us to retain talented people within our ecosystem over the long term, which we consider to be the single most important driver of sustainable long term success
3 To be fair, as Kauffman points out in their report, LPs are enablers of this and if a manager can charge 2% (or more) of AUM and their customers (the LPs) are willing to pay this, there is nothing intrinsically wrong with this if it is justified by performance. I would however suggest a modification that would both allow great managers to charge whatever the market will bear and better align outcomes. For all management fees above the operating costs of the firm, the GPs could “re-invest” this surplus in the fund. Note this throws up some complications in a fund structure (in an equity structure such as ours, this would simply mean paying out surplus “management fees” as restricted equity) but I don’t think it would be impossible to come up with a decent solution. Even if not perfect, it would clearly drive a better GP/LP alignment. Indeed this is effectively what (most) of the best hedge fund managers do, essentially re-investing their surplus income back into their fund(s). Clearly this is easier with a hedge fund that will often have daily or at least monthly NAVs but again I don’t think it would be impossible to come up with a reasonable methodology to enable something similar for venture GPs.
4 (from Berkshire Hathaway’s “Owner’s Manual”):
“Intrinsic value is an all-important concept that offers the only logical approach to evaluating the relative attractiveness of investments and businesses. Intrinsic value can be defined simply: It is the discounted value of the cash that can be taken out of a business during its remaining life. The calculation of intrinsic value, though, is not so simple. As our definition suggests, intrinsic value is an estimate rather than a precise figure, and it is additionally an estimate that must be changed if interest rates move or forecasts of future cash flows are revised. Two people looking at the same set of facts, moreover â€“ and this would apply even to Charlie and me â€“ will almost inevitably come up with at least slightly different intrinsic value figures. That is one reason we never give you our estimates of intrinsic value. What our annual reports do supply, though, are the facts that we ourselves use to calculate this valueâ€¦
â€¦Inadequate though they are in telling the story, we give you Berkshireâ€™s book-value figures because they today serve as a rough, albeit significantly understated, tracking measure for Berkshireâ€™s intrinsic value. In other words, the percentage change in book value in any given year is likely to be reasonably close to that yearâ€™s change in intrinsic value. You can gain some insight into the differences between book value and intrinsic value by looking at one form of investment, a college education. Think of the educationâ€™s cost as its â€œbook value.â€ If this cost is to be accurate, it should include the earnings that were foregone by the student because he chose college rather than a job. For this exercise, we will ignore the important non-economic benefits of an education and focus strictly on its economic value. First, we must estimate the earnings that the graduate will receive over his lifetime and subtract from that figure an estimate of what he would have earned had he lacked his education. That gives us an excess earnings figure, which must then be discounted, at an appropriate interest rate, back to graduation day. The dollar result equals the intrinsic economic value of the education. Some graduates will find that the book value of their education exceeds its intrinsic value, which means that whoever paid for the education didnâ€™t get his moneyâ€™s worth. In other cases, the intrinsic value of an education will far exceed its book value, a result that proves capital was wisely deployed. In all cases, what is clear is that book value is meaningless as an indicator of intrinsic value.”
5 Indeed, I kind of regret not having done so with Anthemis by shorting one or two of the broad public financial sector indices at the same time as going long Anthemis. Although having been very long financials in 2006 (structurally as a result of my 16 years in banking), I can’t complain too much having sold down as quickly as possible my direct holdings and implicitly – by leaving my job – my ongoing embedded exposureâ€¦ As an example, Weatherbill (now Climate Corporation) where I led the angel round in 2006 is now worth upwards of 9x where I invested, whereas Allianz (where I worked via DrKW) is down c. 40%! If you use Commerzbank as a proxy for Dresdner (RIP) it’s down by c. 95%!! And yet investors still consider public stocks like these less risky than venture stage companiesâ€¦go figure.
I don’t have much invested in traditional public equity markets, just a handful of relatively small positions in my (self-directed) pension fund. I haven’t done any robust analysis but my intuition tells me that my average holding period for these positions is probably around 2-3 years, with perhaps a bit of trading (lightening up or adding to existing positions) one or twice a year. And watching the markets from the sidelines over the past month or so certainly hasn’t made me regret this modest, passive allocation. When massive, mature companies trade up and down by 10 or 20% in a period of days – with no or little company specific news, confidence in the market’s ability to set prices in an orderly fashion clearly goes out the window. Indeed, the (public) equity markets are dangerously close to losing their ability to provide one of their key benefits: price discovery. And if/when this comes to pass, there will be serious knock-on effects on their other prime (and beneficial) function of capital allocation (and providing access to capital to companies and access to companies to investors.)
The risk is that a tipping point is reached at which the traditional public equity markets cease to be relevant venues for raising capital or investing. As many people have recently remarked (Kill the Quants Before They Kill Us, Beat high-frequency trading machines by not playing their game, etc.) possibly the key driver of this trend is the relentless increase in algorithmically-driven machine trading (high-frenquency or otherwise.) Now don’t get me wrong, I am neither a luddite, nor am I fundamentally opposed to these trading strategies; rather all other things being equal I would probably consider myself a proponent. In moderation, these types of trading strategies add both liquidity and heterogeneity to the market and as such help create a more robust trading ecosystem. But recently, the equilibrium of this system has come unstuck. Anecdotally, it is now assumed that upwards of 60% of trading volumes on the main public stock exchanges are accounted for by algorithmic/machine-directed trading. On some days and in some stocks, I understand that this can be as much as 80+%.
And most of these strategies don’t involve any judgement as to the valuation per se of a company; basically, as the Onion put it so brilliantly many years ago: they are just “trading” a “blue line”.
NEW YORKâ€“Excitement swept the financial world Monday, when a blue line jumped more than 11 percent, passing four black horizontal lines as it rose from 367.22 to 408.85.
So nobody is actually setting the price! (…or more accurately, the “price-setters” in the markets are mostly being overwhelmed by the trend-trading machines.) This does have the side effect of creating real trading and investment opportunities for on the one hand a small number of smart nimble day traders and on the other hand a small number of very long term investors (who have the luxury of having deep pockets and patience) but for the vast majority of investors (professional or private) the market dynamics and extreme short term volatility make participation more and more painful. This is particularly the case in a low-return environment such as today. Clearly execution (entry and exit points) have always been important, even to long term investors, but never have they been make or break like they have been in August: who cares if you have a carefully crafted investment thesis that predicts a 20-40% appreciation over 2-3 years in Company A when depending on the day of the week on which you entered the position, the thesis is rendered somewhat moot by a 20% swing in the share price.
And it’s no wonder that strong, growing private companies are often loathe to have their shares listed: what right-thinking CEO wants to deal with that insanity???
So what’s the solution? I don’t pretend to have an answer, but I do have a couple suggestions that perhaps point in the right direction for smarter people than I to develop into actionable plans:
- design structural dampeners (through exchange rules and regulations) that limit the volume of algorithmic trading to some maximum proportion (to be A/B tested to find the optimal point – 40? 50? 60? percent?); this could also be a dynamic number, for example increasing or decreasing with intraday volatility to damp same
- encourage the continued development of private secondary markets (SharesPost, SecondMarket and others) and help to develop them as real alternatives (and complements) to traditional public equity markets.
It’s really important that our global capital markets operate robustly and efficiently. In fact it’s never been more important. I believe that reasonable, robust solutions exist (or can be developed.) But I fear that the inertia and prejudices of entrenched incumbents (exchanges, banks, regulators, governments and investors) will make finding these solutions exceedingly difficult. I hope I’m wrong. Until then, be careful out there (and think about re-allocating some of your capital to the private markets; you’ll sleep better at night!)
Very excited to be making my first trip to Bulgaria later this week for TISEE 2011 which we have generously been invited to co-host by Pavel and Deven of Neveq who are the brains and the driving force behind what I’m sure will be a fascinating day:
The Technology Innovation Summit: Eastern Europe (TISEE) is an annual gathering of leading technology visionaries, executives, investors, and entrepreneurs. The event is focused on bringing exposure to the Eastern European technology landscape and connecting innovative companies in the region with global leaders in these fields.
There will be a broad set of events including keynotes, interactive panels, networking sessions, and a startup competition focused on emerging technologies, with a particular focus on Financial Technology, Mobile Technology, and Online Services (social media, personalization, etc.).
There is a great line-up of speakers, panelists and attendees both local and international. If you don’t have plans for Thursday, you can still book your place and jump on a plane to Sofia Wednesday evening. I’m sure you’ll enjoy it. If not, follow @TISEE2011 and/or the #TISEE hashtag on the day to follow along from home.
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.) Â 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 â€œgainedâ€ 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. Â As Keynes said, “the markets can stay irrational, longer than you can stay solvent…” Â 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. Â (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. Â But I do have some skills. Â And some experience. Â And I can recognise patterns reasonably well. Â And I have conviction. Â And a reasonable track record for building new markets and adopting and executing novel business models. Â 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. Â 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. Â In fact it’s pretty obvious. Â 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. Â 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.) Â As someone wise once said: Â a “start-up is not GM” Â 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. Â In fact as most people would glibly observe, investing in start-ups is ‘very risky’. Â Well yes, but the risk is almost entirely idiosyncratic and manageable – much much less dependent on vast, uncontrollable, macro-economic trends and forces. Â 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)? Â 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. Â 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. Â 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. Â 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. Â 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. Â 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. Â 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. Â And while I am confident in my own abilities and have backed that up with a lot of “skin in the game”, Â 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 Â – in new companies, are excellent and, for the VaR-boys out there, truly uncorrelated to mainstream asset classes. Â The challenge is of course to find these investors and not to swamp them with too much capital. Â 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. Â 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.) Â 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. Â 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*.) Â 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!) Â It completely revolutionised what had heretofore been a disjointed, manual, somewhat ad hoc process into a seamless, collaborative, mostly painless process. Â 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.) Â 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.) Â 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. Â 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; Â 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). Â Further, there is much talk (and consensus) around the fact that it is hard/impossible to scale venture investing. Â 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. Â Not to infinity but substantially, perhaps by an order of magnitude. Â 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.) Â Then came Bloomberg. Â And excel spreadsheets. Â (And later bespoke pricing and analytic tools and platforms.) Â And all of the sudden, a trader could manage a book with hundreds of securities. Â 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. Â 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. Â But while this (and excel for traders) is (was) a good start, the real juice comes when dedicated, purpose-built platforms emerge. Â If you have a screw that needs driving, a hammer is better than nothing (or a rock) but a screwdriver is even better! Â (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.Â 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. Â 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. Â 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. Â 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? Â 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 withÂ 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… Â 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. Â 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? Â 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)? Â 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. Â 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. Â 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 likeÂ Second Market andÂ SharesPost have provided to early investors and employees. Â 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. Â 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. Â 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”. Â 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, Â including later stage investors (aka mainstream venture capital funds.) Â 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. Â Practically speaking, what would this mean? Â 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. Â 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. Â 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. Â 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. Â 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: Â 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: Â 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. Â Nor that all seed investors would always be happy to sell all or even part of any individual investment. Â Nor that later stage investors should always look to buy out early stage investors. Â 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. Â Let’s get rid of the dogma and let markets work. Â Liquidity: Â not too much, not too little, let’s get it right!
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.
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.
Today Kublax announced that it was closing down:
The race the create the Mint.com for the UK has claimed its first victim. Kublax, a Seedcamp 2007 winner which launched in August 2008, has now gone into administration, saying it was unable to secure a further funding round.
I’m pretty disappointed to tell the truth. Not so much because we held a small stake (via our investment in seedcamp) although this is unfortunate, but mainly because I think their business proposition is valid and although they certainly made mistakes along the way, these mistakes were probably avoidable and actually more to do with raising capital and managing a start-up than anything specific to Kublax. Of course to be fair, in any new venture all aspects of execution are at least as important as the idea and/or market opportunity and a two-legged stool won’t stand. Debating which leg is missing or broken and why is ultimately a somewhat irrelevant exercise. The reality is they didn’t make it happen. Nonetheless I feel badly for Tom and Sri, who I know put a lot of passion and effort into building Kublax and stayed focused and pragmatic to the end.
The general (ie non Kublax-specific) lesson that I would put at the heart of a case-study on Kublax is that capital is important. Now that might sound blindingly obvious – and of course it is – but stay with me. The lesson I see is that not all (‘tech’) start-ups can succeed bootstrapping a few hundred thousand pounds into a sustainable business model. As a relative outsider, I have and remained perplexed by the ‘one-size-fits-all’ capital model that seems pervasive in European venture capital, which often in reality turns into a feast or famine of capital for individual start-ups. Kublax was built on a shoestring and quite frankly it showed. The chicken never laid the egg and so the end became an inevitability. But I wonder if it could have been different.
You might be wondering why we didn’t invest in Kublax.* It really came down to one thing: we did not have the capital resources required to allow Kublax to hit ‘escape velocity’. I have looked very closely at Kublax over the last 18 months, and indeed we wanted to invest. However as a result of our analysis, we believed that the best risk/reward scenario would have required them to raise at least Â£2 million pounds and possibly as much as Â£5 million. Upfront. Not being in a position to provide this quantum of finance at the time, it would have been foolhardy to commit capital only to be ultimately at the mercy of other people’s investment committees. Further – and accuse me of hubris if you like – we felt strongly that our specific skills, knowledge and networks would be able to materially help the company successfully address some of it’s key strategic and operational challenges. However it would not have been economically rational for us to deploy these resources against only a modest investment. So we were confined to waiting on the touch line for others to drive the process. In the event, none did.
Lack of capital was not the only problem at Kublax, but I think the other key issues that the company faced could all have been addressed given sufficient capital. I will highlight four examples:
- capital structure (specifically who owned how much and why)
- management depth and experience (in particular in financial services)
- product and user experience (never evolved beyond alpha quality); and
- marketing and brand awareness
All of these issues could possibly have been solved with an appropriate infusion of capital from a serious and domain-knowledgeable investor. A cynic might point out that these four factors are pretty much the only four factors that matter so saying you would invest subject to being able to improve these is tantamount to saying you would invest if the company was ‘good.’ Well yes. Sort of. I think in the case of Kublax, the investment decision would have boiled down to a ‘build vs buy’ logic. Starting from scratch is hard and for all its faults, Kublax had done a lot of the basic plumbing (hard, unrewarding but necessary) and didn’t get a chance to start laying the tiles (hard but rewarding.) I find it hard to believe that asset is of no value.
In any event, given Kublax’s seedcamp pedigree, I imagine that most or all of the establishment London venture capital firms had the opportunity to look at Kublax. I think it would be very interesting and helpful to the broader UK/European start-up ecosystem to understand the key factors that informed their decisions to pass. Ask your favorite London VC to comment below.
So would we have invested if we had been in a position to underwrite a Â£2-5 million investment? Quite possibly. And indeed we would have made a determination on each of the four points above to really understand if these issues could be addressed, and the execution risk reduced accordingly. Alternatively we might have decided (and still might in the future) to incubate something similar ourselves.
In any event I wish Tom, Sri and the rest of the team at Kublax all the best for the future and hope they take away as many positives as possible from what must be a very disappointing outcome.
* I am referring here to what I call “Kublax Mark II” – in the early stages of the company’s life there were some clear management issues and dynamics that overshadowed the business and market opportunity. However seen from the outside, the company and it’s shareholders eventually addressed these issues and seemed to have a fresh start with some new investors coming on board and importantly a new CEO (Tom Symonds) early last year. It’s at this point we became interested (having explicitly passed a year earlier due to our lack of confidence in how the company was being managed.) Unfortunately one of the lessons is that it seems in the world of capital raising you often really do only get one chance to make a first impression…