Some Thoughts on Economic Development for Virginia and the GWR

Economic development is just plain hard work.  It doesn’t come from adopting the flavor of the day or the latest idea.  It comes when a region focuses its efforts on creating business and structural advantages to (i) produce high value- added products that are unique and (ii) are not replicable elsewhere.  Economic development requires establishing a long term infrastructure that creates a community and livelihoods for its citizens. It takes time to do properly. 

I am reminded of this most of all when I look at our region’s approach to economic diversification and technology startups.  When I was an international hedge fund trader years ago, my colleagues and I took comfort in the phrase “the trend is your friend.” Nothing was easier for us than jumping on a market trend and riding the momentum.  As long as we jumped on early, and jumped off while others were jumping in, we made money.  It wasn’t our job to think long term – it was our job to find short term momentum in markets and benefit from it.  These days, momentum trading dominates not only the financial markets but also the expectations of investors generally.  Momentum trading has fed into the venture capital industry too; venture capital floods into startups[V1]  in industries that promise momentum towards a quick exit. This has resulted in a skewing of which types of startups get funded, and in what industries entrepreneurs looking for quick riches start companies.

Looking at digital media startups or cybersecurity startups as the path to regional growth is seductive but it’s a view that confuses current momentum driven by the venture capital market with long term economic development opportunities.  It’s easy to go with the prevailing trend, and as is the case with every momentum-based trend, some people will make lots of money.  But the real question people should be asking is this:  “Why can you start a software company with $25,000 and a case of Red Bull”?  You can do it because software is becoming a commodity.  As a member of the faculty at one of our region’s leading business schools, I can tell you that it’s a settled principle that when an industry is based on a commodity product, the way to succeed is through scale and controlling costs.  This explains why so many software startups now develop technology in emerging economies and why the Internet (mobile and fixed) is becoming so concentrated in Google, MSFT, Comcast and a few others.  It also should be a warning that when an industry commoditizes it becomes much harder for startups to become large independent businesses – they cannot acquire sufficient profits to be sustainable.

As I read about the changes in DOD Budgets, announcement of DC-government funded digital tech investment, and calls for economic diversification, I see a worrisome congruence in thinking: people are mistaking transitory momentum in startup activity for an enduring long term opportunity.

Our region has the highest concentration of scientific funding and researchers in the United States.  Our nation’s federally funded R&D has fostered and funded the development of every important technological trend in our nation since the creation of the transcontinental railroads.  Countless innovations that you know about (Siri, GPS, semiconductors, and biotechnology) and some you don’t (driverless cars[V2] , artificial limbs, bendable metals, and proteomics) are being developed every year under the guidance of our national security agencies.  When new technologies come to market they are unique and command high value added pricing. They are not commodities.  They become the backbones of new industries, and very, very rewarding for the entrepreneurs and regions that foster them.    

Working to create new industries is much harder than following momentum, but ultimately it is more profitable.  By focusing our region’s efforts on mining the technology and innovations currently being funded by our national security agencies, we create the possibility for our region to be the leader in the establishment of new industries, with high value added jobs and startups.  Much of the technology that will shape the next 30 years of our nation’s economy is being developed in our midst.  Shouldn’t we focus on commercializing it?

Why Amplifier Ventures Launched Tandem NSI

When I think about our national political climate these days, I am like many Americans saddened by the hyper-partisan nature of things. For most of us, the constant wrangling about budgets, healthcare and “gotcha” politics is both exhausting and also less and less relevant to our daily lives.  You can feel the growing alienation, and see how it reflects in the polls.  In trying to come up with a way to explain it all, and being an optimistic person by nature, I have wanted to look past our current partisan follies and look to the future.  And, that is when it hit me.  Today’s political infighting is reflective of an unspoken almost uniform cause.

For some it manifests as a fear that taxes will go up. For others, it is the fear that they’ll never get a job. For many it is a sense that the challenge of keeping up is an irreconcilably losing game.  Fear drives politics these days, and fear keeps us from listening to each other.  But, what is not being discussed is the basic fear that is driving all of these manifestations: a fear that the United States’ economy can no longer grow to create wealth and opportunity for all of us.  This fear causes us to seek austerity, to worry about debt, to focus on inequality and to distrust one another.  And, make no mistake, it is profoundly powerful and deep-seated.

I, for one, do not think that our opportunities for growth have passed.  But, I do think that our politicians are not looking in the right places.  Caught up in the current doctrinal food fight is the role of government and innovation.  And as a result, government investment in technology is caught up in the spider web of sequestration and budgetary posturing.  But what is lost in this conversation is the unassailable fact that government technology investment, particularly through the Department of Defense, is a major driver of economic growth and innovation in the U.S. economy.

From the railroads onward, the industrial waves that have shaped our economy and established the United States’ industrial primacy were fostered and shaped by national security spending and entrepreneurial activity.  The airplanes you fly in, the cars you drive, the computer you use, and the phone that allows you to keep up with your friends on Facebook all wouldn’t exist today in the form that they do without a strong relationship between government and entrepreneurship.  As a venture capitalist, I spend my time trying to find companies to start and sell within a short period of time.  I don’t create industrial waves — I invest in the companies that ride them.  And that is true for any venture investor.

I therefore believe it is essential that all of us who care about growth — and I think that what our current political environment shows is that we all care mightily — must communicate to our political leaders that we expect them to make intelligent decisions about how to spend or not spend our money.  They must invest in our future growth.

With that in mind, Amplifier Ventures has  partnered with the Commonwealth of Virginia and Arlington Economic Development to create a public/private partnership to promote a tighter link between national security agencies and entrepreneurs.  It is called  Tandem NSI – which captures the importance of these two important drivers of economic growth.  Perhaps most significantly, the public capital for this initiative was provided by a Republican governor to a Democratic leaning county and a private sector venture capital firm.

As we operate Tandem NSI in the coming months we hope to provide our friends in Congress with an example of how nonpartisan considerations of growth and opportunity can allow us to make rational choices on how we allocate our time and national wealth.  We think it’s better to build new furniture.

Crowd Equity Will Not Live Up To The Hype

The JOBS Act reminds me of the old joke about the elephant and the blind men.  An elephant looks very different depending upon which part you’re touching.  There’s lots of hype around the concept of crowd equity for sure – almost breathless at times. This week’s announcement that the SEC is moving forward with rules to effect the intent of the Act – to allow unaccredited investors (i.e.., not wealthy people) to invest in startups through on line exchanges – was no exception.  Make no mistake, allowing people who are not well off to invest up to $5,000 in the stock of a small privately held company is a big change – it undermines 80+ years of securities laws based upon a simple principle: in the absence of a test for financial sophistication, having sufficient assets to absorb an investment loss is the best protection for investors.

But, is it a big deal for startups and investors?  Sadly, as a practical matter, there are aspects of this new regime that will create an adverse selection bias against the best opportunities being available on online exchanges targeted at non accredited investors.  Here are some of the reasons why I have this concern:

Most Exits Are Not Public Offerings 

Investors invest to make money – this means that they must have a way to monetize their investment.  A company becoming publicly traded is undoubtedly the best way for small shareholders to achieve liquidity.  However, most liquidity events are not companies becoming public.  The most likely outcome for a startup investment is – ready?  The company failing.  The second most likely is a sale of the company as a whole.  And, in this case what the seller gets back more often than not is more stock (think of it as the equivalent of winning a pie eating contest and getting more pie).  Without a public offering, holders of crowd equity are going to have a hard time getting money for their investments.  I sincerely doubt that this reality is likely to be widely known by the participants in the online portals – Facebook is the exception, not the rule.

Crowds are Not Wise 

One of the primary rationale behind letting the not wealthy invest in startups is that it will be done solely through online exchanges where the wisdom of crowds will monitor and weed out bad investments or shady promoters.  Nice idea, but the words wisdom and crowds don’t often interact when it comes to hard things that require expertise. What I have seen through my teaching of group dynamics and being a former hedge fund trader, is that absent some sort of credentialing process, groups tend to dumb down, not smart up, when it comes to complex challenges like investing. 

You can use the wisdom of crowds for capturing group behavior and sentiment (which is why I think that crowd funding of projects works well), but it falls apart when sophisticated analysis is required.  For example, Wikipedia, the acknowledged symbol of the wisdom of crowds, is actually a curated site with a group of experts that edit and confirm the content.  Another example?  Look at your own Facebook feed. What is being talked about generally is interesting for gathering sentiment, but when you are looking for information you tend to look to the experts in your feed – people whose opinions you respect.  My point is that it will not be the crowd that regulates investments online, it will be the people who turn out to be reliable indicators of the quality of a company. In other words, the crowd will seek and crave curation – and I am very concerned that this craving will result in greater possibility of manipulation from supposed experts.  Because….

Experts Will Not Be Incentivized to Curate for the Crowd

While it’s nice to imagine that enlightened people will inform and lead online investment behavior, and I am sure some will try, the reality is that having a good sense of what makes an investment compelling is a skill.  It is skill that is gained through experience, contacts, hard work and a bit of luck.  Even if you believe that startup investing success can be quantified (see 500 Startups), the tools for doing so are not developed easily or for free.  In my experience, people who invest their own time and money to develop investment skills tend to want to be compensated for it with something other than karma. The availability of competing online models that will allow for compensation (Angel List syndicates, for example) and physical world possibilities (being a GP in a venture fund or making direct investments as an Angel investor) will undoubtedly shade the interests of skilled experts in crowd equity markets. 

Having Small Stockholders is a Nuisance or Worse

As mentioned above, most exits are business sales where stock (or cash) will be paid to the stockholders.  Dealing with small holders in a corporation, particularly a startup, will add compliance expense and logistical challenges.  Moreover, the securities laws principles and state corporate laws governing the purchase of stock for stock may make certain transactions impossible if there are non-wealthy small holders in a company.  This is not a small point. I’ve done hundreds of M&A deals over the years, and companies that have small holders are a nightmare.  And, nothing in the JOBS Act addresses these issues.

Because of these limitations and challenges, my concern is that the JOBS Act online exchanges will not attract the best companies – it will not be worth the effort for the companies, nor for the experts who support them.  I fear that the pull of proprietary deal flow – where the best deals are closely held by those that have the best skills and networks – will remain in place.  A parallel online market – centered on accredited investors – seems much more likely to challenge existing structures.  And, crowd funding on projects, which relies much more on sentiment, will also succeed.  But, crowd equity?  I just don’t think it’s worth the hype.

You Don’t Have to Go to the Valley!

This morning there is a blog post circulating which states that to build a start up anywhere other than Silicon Valley is foolish.  The post, which is presented in a highly respected outlet, states that by looking at financing patters in the venture capital industry a clear conclusion is reached.  To grow a startup you must locate where the money is, and that is Silicon Valley.

While this appears to be very sound logic, it is actually based upon an incorrect view of causality.  Entrepreneurs do not follow the money – the money follows the entrepreneurs.  To look at the current level of funding activity and conclude that entrepreneurs should locate in the Valley is like someone who is interested in cooking some marshmallows looking for the last place there was a forest fire.  The reality of modern startup financing – a VC industry consolidating into larger funds that are chasing shorter investment horizon deals and a growing reliance on Angels and crowdfunding — provides an exceptional level of bias towards momentum investing in industrial sectors that provide a high probability of quick exit.  Within the world of consumer internet and related mobile startups the region of the US that provides this possibility is clearly Silicon Valley.

Last year I released a White Paper on M&A Patterns in Silicon Valley and the Greater Washington Region.  I looked at every M&A transaction reported in these markets from 2006 through 2011.  What I learned was interesting: (i) where there is a high concentration of intra market transactions startup formation and growth is accelerated, (ii) Silicon Valley’s technology M&A market is driven by a relatively narrow range of industrial segments, while the GWR’s M&A market is significantly more diverse and (iii) the GWR M&A market has been surprisingly robust, even in comparison to Silicon Valley.  In fact, measured by numbers of deals, overall M&A activity was comparable.

The most important conclusion from the data is that where you have a high correlation between startup activity and the regional incumbents (the dominant larger companies in an industry), a high velocity of exit activity occurs.  As our public markets continue to punish companies for engaging in R&D, more and more product and service innovation is “outsourced” to the startup sector.  This pattern of behavior recurs in each important technology sector of our economy, particularly as they mature.  What this means is that if you are operating your business in a region that is dominated by companies such as Google, MSFT, Facebook and so forth, you are much more likely to be purchased if you create a business that is useful to them.  This is particularly true if your goal is to be an acquihire.

What is important to ask, however, is whether current M&A patterns will be permanent.  It is also timely to ask whether the current dominance of consumer related Internet businesses is a permanent aspect of tech entrepreneurship.  I believe that we are all missing the point if we look for the last forest fire.  As a society we should be looking forward and not back.

The reality for both entrepreneurs and our policy makers is that industrial waves come and go, and the largest growth opportunities occur at the beginning of waves, not at the end.  The next waves are being funded by national security R&D, and as they become clearer, the regions that dominate them will be where the dominant companies are created and M&A activity will be most dynamic.  That may or may not be Silicon Valley.  Personally, I believe that the Greater Washington Region is likely to be the home of one or more of the dominant companies of the next waves, because of its high connection between government and entrepreneurship (this is an argument I have made elsewhere).

My overall message to entrepreneurs is simple.  If your goal is to grow a business that is sellable in the short term, you should build a business that your local larger companies will want to buy.  If your goal is to grow a business that is durable, you need to grow a business where you can find the resources you need – human capital and customers being the most important.  In my experience, money will follow a compelling business, regardless of location if you can find the resources.  And, if you can grow a business to national importance, and have sufficient organizational development, you can go public and become an incumbent yourself, and startups will grow up around you.

In other words, don’t follow the money to grow a business.  Figure out the strengths of your region to grow the business you want to grow.  And, understand that the dynamics that shape the flow of money are a lagging, and not a leading, indicator of where you are most likely to be successful.

The Future Is Messy and We Aren’t Even Close to Ready

As I have read the various articles and blogs about Google Glass over the last few weeks, it has led me to marvel at how completely people are missing the point.  Whether it’s arguing that Google Glass won’t be attractive to consumers, or it’s Congress worrying about privacy, it just strikes me as a side show.  Kind of like arguing while Nero played the violin about his choice of bow resin, song choice or quality of the performance.

It’s not just in connection with Google Glass.  Over the last few weeks there have been more than a few observations made about the possibility of creating machine and software based vessels for the human brain and consciousness.  Will it work? Won’t it? Will you still be you if your brain is transferred to the web?

Here’s my point, technology advances because of the combination of human curiosity, the desire of innovators and inventors to leave their mark on the world and plain and simple commerce.  So long as some part of our world provides incentives (or at least doesn’t prohibit it), technology will continue to progress.  Technology and humanity have become intertwined, as a form of expression and as part of a complex feedback loop.  As technology advances, it creates challenges to existing social structures and the status quo, and ultimately shapes society.  Which, leads to further changes and so forth.

For example, technology has given us the ability to communicate via phone, email and messaging as we move through our day.  Look how that change has shaped and changed society.  What is acceptable behavior in social settings have changed.  I bet you weren’t upset when a colleague took a look at her Blackberry during lunch (you probably took a quick glance at your iPhone at the same time). Think about the email/text you sent ahead of the meal saying “you would be five minutes late.”  It used to be that being on time was showing up on time – now on time is sending a message of your likely arrival time.  These simple examples show how the existence of the technology of ubiquitous communication have changed social conventions. 

There are many other examples.  Consider how the existence and structure of the web has changed how people get information about the world, and how fragmented our political system has become.  It’s not an accident.  Have you thought about oil fracking recently?  Think how our country will change as it becomes energy independent – with hydrocarbons that pollute our water table, perhaps.  And have you really thought about the implications of autonomous cars, 3D printed guns and cybernetic limbs? How about artificial life (created from real DNA), quantum computing or mining space?

One of the things that I find most concerning about our current political climate is how our representatives spend many hours arguing about a future that they haven’t really thought through. They argue about privacy where the horse is already so out of the barn he is over the hill and far away. They argue about “death panels” as medical technology converges on technologies to allow humans to live for extended periods.  They argue about how to create free markets, while they enable concentration of our dominant industries.  But, what they rarely do is think ahead.

However, in this case I do think that they are truly representative of our democracy.  These days we do not really spend much time thinking about the future as it will be shaped by technology, and instead speak more and more of the need for austerity.  Discussions of a different future are somehow seen as trivial and “not serious” as we are encouraged more and more to believe in a future of scarcity.  By doing this we end up limiting our horizons and ability to make good decisions about how our country will progress.  This is a mistake.  History shows us clearly that for good or for ill the one thing that we can count on is that technology will progress, and change will occur. 

Here are some examples that come to mind:

  1. Assume that advances in medical technologies continue as they are.  Within a relatively short time horizon, technologies will exist that will dramatically expand the lifespan of humans.  Who will get these technologies?  How will they apportioned?  Just for fun, imagine a world where they go to those that can afford them.  Or, a world where they apportioned by lottery.  They would be very different societies.

  2. Assume that Google Glass and Siri are the thin edge of a trend. Within the next ten years the line between what we know, and what we can find out, will blur to the point of unrecognizability.  What will knowledge mean when all knowledge is available by asking the right questions of our personal assistant?  Think we are educating our children properly for this world?  Think education will matter?

  3. Assume that data mining and surveillance technologies continue to advance.  What will privacy mean?  Who will care?  How will you react when it becomes clear that there is in fact nothing unknowable about you to the government, advertiser, employer, colleague or stranger?

  4. Assume that 3D printing progresses to a point where first simple manufacturing and eventually complex manufacturing can be done on a desk top machine.  What will happen to manufacturing employment as a result?  How will intellectual property rights be handled?  What will it mean to work, or not to?

I could go on for many more paragraphs but by now I expect you have seen my point.  The future won’t be like today, but the way that society adapts to new technologies will define what that future becomes.  We can either engage in meaningless discussions on the side show, or we can address the real issues at hand.  The more that we look ahead to the challenges that technology can create, the more likely we are to benefit from them.

A VC’s Opinion: Yes You Should Get an Education

It seems some days that getting an education is portrayed as the pursuit of mugs and fools.  I have lost count of the articles and blogs I read, and the talking heads I hear, spouting nonsense about the folly of pursuing a college education or an advanced degree like an MBA.  It is a large and recurring theme in startup land – the argument that real entrepreneurs don’t need an education, or that an education (or an MBA) is just an impediment to the inherent greatness and creativity of the entrepreneur.  It’s a theme presented through the images of the down trodden BAs who can’t get jobs, and stories of overpriced liberal arts colleges pumping out graduates with “no skills.”  And, you know what?  It is SO MUCH NONSENSE.

Entrepreneurship is a human behavior, without question.  People who are entrepreneurial often seem to be born into it.  However, growing a successful business is not instinctive. It is a journey, and one that is more likely to be successful if the people involved have knowledge and context to guide their instincts.  Moreover, a successful business needs a team, and some members of the team need to have detailed skills.  One of the best examples of this I have seen is the appreciation of competition. Each business has it, and a successful business must overcome competition to succeed.  An instinctive entrepreneur often believes she has no competition. An educated individual appreciates how markets work and how supply and demand forces shapes competition. In other words, education provides context and a framework for instinct.

While it is wonderfully exciting to talk about high school graduates that succeed because they throw off the shackles of a college education, the reality is that for most mere mortals an education is vitally important.  In a given population, there will always be outliers, of both success (internet millionaire) and failure (BA cab driver), but for the substantial majority of a group, having an education is essential both for themselves and for society as a whole. 

“Any sufficiently advanced technology is indistinguishable from magic.”

Arthur C. Clarke

We live in a highly complex society and world.  Material and physical science has progressed to the point where the composition of matter can be explained from the subatomic level upward to the universe itself.  The understanding of the composition of DNA and the mechanics of life has progressed to a level of understanding that allows scientists to utilize software to predict protein sequences and use DNA to store computer data.  We are linked together through spinning electrons, waves, minerals and materials that we can manipulate and triangulate down to the head of a pin.  Our economy is shaped by the creation of money out of thin air, traded by computers and converted into goods, and then back again in a complex ballet of interrelationships.  There are dependencies, externalities, ideologies and typologies everywhere you look.  If you think that you can understand this last paragraph by instinct I wish you the best.

Without education and the ability to gather an appreciation for the highly complex world within which we now live, a citizen cannot really participate.  You can’t compete in a game where you don’t have the tools.  In addition, there is something more important at stake.  Without an education the world appears unstructured and random. It appears magical. But, not in a pleasant, Game of Thrones kind of way. It appears magical in the way that anything is possible, and everything is relative.  When that happens, jet contrails in the sky can be a government plot to seed clouds just as easily as a natural reaction to jet exhaust in the upper atmosphere, and zero point energy can get just around the corner. 

The reality is that our populace needs to be educated for our democracy to function and our economy to grow.  Society exists because we stand on the shoulders of those that have come before.  We build our lives on the knowledge that our predecessors leave behind.  Today’s software engineers use technology built by those that come before, and our scientists build knowledge on the theories proven by those that preceded them.  Politics and social trends are built upon the experiences of our parents and so forth.  None of us figure out everything during our lifetime, no matter how smart and brilliant we are. Moreover, we are smarter and progress further, when we get the head start of the knowledge of those that have come before.

This does not mean, however, that our education system gets a pass as it currently exists.  Many of our universities have wildly inefficient business models, and have raised their prices not because of inherent value, but as a way to signal exclusivity and limit access.  The world of education, particularly higher education, needs structural reform.  However, to state that the education industry needs to understand and serve its customers is not the same thing as saying that the product that they sell is not valuable.

Overall, my belief is that an education, of whatever type, provides value to the student if the student applies herself and develops the ability to stand on the shoulders of those that have come before.  It is up to the student to decide whether the education overall allows her to stand on shoulders that matter and provide opportunity (in other words, whether learning Eastern European literature is as economically viable as studying Ruby on Rails or chemistry).  The truth of education is that we should support it as a societal value, and leave it to the free market for students to determine what they want to pursue.

The next time you hear a voice argue otherwise, I want you to ask yourself “why does this person rail so loudly against education?”  Or, ask them.  I suspect you’ll find the answer they give will have more to do with themselves than they would like to reveal.

The Capital Market Line — the Dark Matter of the Startup Universe

A few days ago I read a story about Survey Monkey’s recent venture financing. The article pointed out, with a somewhat surprised tone, that Hedge funds were financing expansion stage startups as an alternative to venture funds when a tech startup was seeking an expansion round.  The article reminded me of the many that have been written about the “Series A funding void,” where the decline in the number of venture capital funds is creating a severe mismatch between entrepreneurial startups that are seeking to scale and places to get patient longer term growth capital.  And, it also made me think about the various folks I have heard tell me that crowd equity (when the SEC finally issues regulations) will solve the Series A funding crunch, and bring large amounts of needed capital to entrepreneurs around the US.

What all of these articles, conversations and musings have in common is an implicit assumption: financing startups is a unique and distinctive activity that exists somehow independently from other markets and uses of capital.  For these observers, the only thing that matters for understanding the ability to access startup capital is to understand the identified sources for startup capital.  Unfortunately, this approach is like trying to understand the universe by only discussing what is visible, and forgetting about dark matter.  To truly understand what is occurring in the world of startup financing, and what is likely to occur, you must appreciate the dark matter of the financial markets.

The financial markets are highly complex, and extremely efficient at allocating capital to opportunities for perceived returns.  Efficiency in this context is not a normative term, but is used to describe the ease and rapidity at which a market (for example, the market for milk, or the market for financial assets) adjusts to changes in supply and demand.  Believe it or not the best example of efficiency in the financial markets is the crisis of 2008 and its aftermath.  The markets worked efficiently – pushing capital into a market sector that had high return potential with small perceived risk (mortgage backed securities).  What happened thereafter was the market learned that the risk of holding mortgage related assets was much higher than expected, and market participants rapidly reevaluated the price at which they would purchase these financial assets.  The phrase “not at any price” became the market price for many of these assets, and the cascade of repricing resulted in a near collapse of the financial system. Forget about your political leanings for the moment which cause you to apportion blame (it was the fault of greedy buyers of houses, Fannie Mae, greedy bankers, blah, blah).  The financial market did what it always does when left to its own devices – it moves capital to where investors think that they can get the best returns with the least corresponding risk.

“Ah, ha,” you say, “but markets aren’t about people looking for returns without risk!  How do you explain Angel and venture capital investments?  There’s lots of risk there.”  You are absolutely correct.  But, here is the key point – investors do not look for investments without risk: they look for investments where the risk that they take is compensated for with an appropriate level of return.  Simply put, investors demand more return on their investments the riskier an investment opportunity.  And, in fact, they look for investments where they are overcompensated for the risk with a higher comparative return.  In other words, they try to find investments where for some reason their perceptions of actual risk are less than the market generally, so that they can get an investment with a higher return potential than they otherwise should.  It is the constant push/pull of investors trying to get higher comparative returns, and the sellers of investments wishing to offer the lowest possible return potential, that makes financial markets work.  When agreements as to the correct level of price and risk occur, a sale of an investment takes place.

This matching of buyers and sellers, and the allocation of risk versus return happens throughout our financial markets on a constant basis.  Business people often think of these market allocations as occurring in a continuum, where each investment opportunity is evaluated on the same criteria (return versus risk).  They describe this continuum as the Capital Market Line.  The CML looks like this:

The Capital Market Line

Because of the highly efficient characteristics of the world financial markets, most financial investment opportunities around the world exist on the CML.  Certainly, because the US financial markets are the most efficient financial market in the world, each US investment opportunity, whether it is a Series A investment in a startup or the purchase of US Treasury Bonds exists on the same market continuum.  Which brings us to the reason for the foregoing explanation – if you want to understand the world of financing of startups, you need to understand the CML and the factors currently affecting it.  So, with that, here are few big ones:

  • The financial markets are presently dominated by a desire for short term, highly liquid investments.  Liquidity is a term that is used by financial market participants to describe how quickly they can turn an investment into cash.  There are a number of salient reasons for this focus on short term investments with high liquidity, including the financial crisis of 2008/2009, geopolitical challenges (i.e., Iran and the atom bomb or China and Japan fighting over a small island) and the continual drum beat of political risk (i.e., strikes in Greece, Elections in Italy and Sequestration in the US).  Investors are highly motivated to have liquidity to get their capital back and “run for cover” from the next to occur market panic.
  • Financial markets reward the people who can generate high returns while maintaining liquidity.  A Hedge fund manager can legally take 20 to 50% of his investors’ profits for himself.  A banking proprietary desk manager can make $20 million a year doing his job well (which, by the way looks a lot like managing a Hedge fund).  As a general matter, the highest compensated investment professionals can make $1bn or more a year managing a Hedge fund.  In an industry where “keeping up with the Joneses” means how are you compensated vis-à-vis your friends, the compensation of Hedge fund managers drives behavior in the financial markets in a few ways.  Firstly, it drives up compensation requirements for all finance professionals.  Secondly, because, the highest compensation opportunities come from taking a percentage of profits trading opportunities that create immediate high profit potential are favored.
  •  The central banking system is at present much more concerned with combating deflationary pressures and counterbalancing governmental austerity, than inflation. Therefore, they are pushing unprecedented amounts of money into the financial system.  At the moment much of this money is being captured on bank balance sheets (which drives down their need to pay interest to depositors to attract more lending capital).  Concerns that at some point this money will result in higher inflation (which would cause investors to seek higher returns in compensation for the same amount of risk) have so far been unfounded. But, the niggling fear of inflation shapes market perceptions and reinforces investors’ preference for liquid investments.
  • Corporate management of publicly traded companies is shaped by investor preferences.  For most public companies compensation has become more and more tied to stock performance, so this interdependency has become more pronounced.  Therefore, as management of corporate objectives has become more shaped by financial market attitudes, how companies are managed has to comply with general investor attitudes, rather than other factors that might be more relevant to longer term strategic considerations.
  • Investments by individuals in startups are also affected by the same desires for short term and liquidity.  This is why startups that are perceived as having a short time to exit are much more likely to obtain Angel capital.  The clustering of Angel capital around Silicon Valley (and elsewhere) light software startups is an example of this.
  • Where capital is invested in private pools (i.e., venture capital, LBO private equity or Hedge funds), in any given recent period the amount allocated by investors to Hedge funds dwarfs investments in all other types of private pools, by a large factor (in some cases more than 20 times).   Hedge funds are categorically driven to seek short term, high profit potential investments.
  • Investible assets are largely held by the very wealthy (investible assets of more than $10 million) and institutional investors that are investing to satisfy retirement obligations, educational or charitable purposes.  Such investors tend to be conservative in investment appetite (either because they are interested more in wealth preservation than wealth creation, or because they are represented by professional money managers who have a legal duty to be careful in how they manage their client’s capital).  Conversely, very little investible capital is held by middle class or less fortunate individuals.  For example, most individuals currently facing near term retirement in the US have zero (as in no) savings at all.  Only 10% of these people have savings in excess of $250,000 (including their houses).    It could be that as more and more investible capital is in the hands of the top tenth of a percent of households, risky illiquid investments are just not that attractive.

With these facts in mind, and the immutable realities of the CML, what is going on in the world of startup finance is easier to understand.  For example:

Why is there less Series A financing available? 

There is less Series A financing available because the institutions that invest in venture capital funds see other opportunities to achieve required returns with less perceived risk.  Moreover, because a Series A investment has a likely 5 to 8 year term before it ripens (and hopefully generates the expected return), it is less attractive in a world where investors are concerned with short term liquidity.

Will the JOBs Act free up lots of new investment capital?

Probably not from middle class investors (otherwise known as “non accredited investors” since they do not have $1 million in assets or make more than $200,000 a year), since they just don’t have that much savings.  It might make it easier for wealthy individual investors to find new investments, but it’s not going to produce large pools of new capital.  Investments in startups will still have to compete on the CML against prevailing investor requirements for liquidity, less risk and shorter time frame.

Why are Hedge funds, private equity funds and venture capital funds competing more and more for late stage technology companies?

Because the investors in these different pools of capital are fundamentally interested in the same thing: high return, lower risk and greater liquidity.  Investing in a pre-IPO/exit startup can be very lucrative without a high level of perceived risk.  Look at the folks who bought Facebook a year before it went public for example.

Why would a great technology company like Apple Have $137 billion on its balance sheet as cash, rather than investing it in research and development or basic science?

As a public company Apple’s management is motivated to make short term decisions that affect its stock price and perceived expectations of momentum, rather than making long term spending and strategic decisions.

I could go on, but I think that I have made my point. The realities of the financial markets pervade all aspects of financing of startups.  An entrepreneur’s ability to obtain financing is very much tied to how her investment opportunity compares to others on the CML.  Unless it provides sufficient return to compensate for perceived riskiness, an investment opportunity will fail to attract sufficient capital.  Indeed this is where most entrepreneurs fail to achieve funding – they do not understand clearly the true nature of the risk/return tradeoff for their investment, and either price the opportunity incorrectly (too little upside (return) for the investor) or do not appreciate that there are some startups that are just not attractive investments whatever the price (they cannot offer sufficient upside to justify the risk).

The broader market factors which affect how investors look at all financial assets also will come into play.  This means that an entrepreneur must at all times be watching the broader financial markets and political and economic events.

It also means that if entrepreneurs are concerned about the availability of risk capital for their businesses, they should be.  Market demands are not at this moment consistent with a long term investment horizon.  Over time, the market may adjust, through a combination of changes in perceptions of market risk, or a willingness to accept less liquidity for higher return potential.  It’s also possible that governments may intervene to encourage changes in investor behavior.  However, these changes occur, if at all, is something that will happen broadly as part of the overall financial markets, and not narrowly.  My best advice to entrepreneurs is to get to know the dark matter of the financial markets, and to appreciate those factors which while not always reported in Tech Crunch or Venture Beat may as important to the entrepreneur’s financing plans as the next release of iOS or Android.


Raising Money Isn’t Like Dating – It’s More Difficult!

I have often tried to explain the dynamic of fundraising by analogizing it to a human behavior most entrepreneurs are familiar with – dating and relationships.  In saying this I often get nervous laughs from an audience.  My guess is that it reflects an internal thought process in the listener that goes like this.  “Hmmm, that makes no sense…. Wait, I think I get it it…. Oh man, when I think of the goofy things I have done to get ____…. Ugh (nervous laugh).”

Anyway, to extend on the analogy please consider this.  What are you most interested in doing when you are dating:  Getting someone to like you, of course.  Think about how you accomplish this goal.  Are you engaging, interested, a good listener, prompt, well turned out or some other positive characteristic?  Think about all the ways you have acted to try to gain someone’s engagement and attention.   Now, think about the ways that you can undermine this goal.  Have you been clingy, a liar, unpleasant, unkempt, removed or otherwise been negative in some way?  Hopefully, you now see the point in the analogy; connection comes from what you do and how you act.  And, connection with an investor is essential.

Investing, whether done by an Angel, Venture Capitalist, friend or family member requires at its most basic level that the investor like you and trust you.  If you can point to an investment decision in a start up company where the investor going in said “I don’t like and trust the founder, but what the heck, let’s roll the dice” I will publish your comment and give you major kudos.  I have never seen that.  This doesn’t not mean that other factors are not also important – particularly the more that the investor is motivated by achieving financial gains.  Still, at some level the decision to invest is very much about making a connection and the entrepreneur being perceived in a positive way.

My experience with the importance of a positive connection extends after the initial investment.  The reality of start up life is that it is hard to achieve success, and it is at best a circuitous path.  There will be times when disaster seems behind every turn, and moments when all that seems to remain is to count the money that is about to come in.  The mayhem of being in a start up is only really analogous to raising a child (but that is another story for another blog).

If an investor does not trust the entrepreneur then at these times of uncertainty for the start up, the lack of trust will result in a higher likelihood of investor disappointment, intervention and recrimination.  Having a positive engagement with the investors in a start up is essential.  So, again, we go back to Dr. Phil and relationships.  Think of all the ways you keep a relationship going.  And, all the ways you mess them up.  It all applies to start up life and how you work with investors.

So, raising money and interacting with investors is like dating.  It is, but it’s also much more difficult.  You know why?  It’s a lot easier to have a positive result out of a date….  Here’s what I mean.  There are roughly 70,000 Angel investment deals done a year, and roughly 4,000 VC deals.  Compare that to the number of new businesses started each month – roughly 500,000.  The percentages for getting an investment from a stranger is just not that favorable.

The implication of this is that if you are looking to raise money for a start up then for each investor meeting that you take, there is only ONE positive outcome that truly matters: you get the investor to invest.  Who really cares if you have a nice time, or enjoy each other’s company?  You just want the investor’s money.   There are many, many more ways for a date or relationship to be a positive experience.  And, that brings me to my last point.

Before you look for capital, you need to be ready for rejection.  A high percentage of rejection, and much higher than the rejection (hopefully) you have experienced at any other time of your life, including dating.  For an activity that requires so much personal attention and energy, fundraising is unbelievably hard for that reason.  Moreover, it is hard not to take the failure to raise money personally, since it feels for the entrepreneur that he is extending himself in the most vulnerable way:  “look what I have built, don’t you just love it?”

Therefore, my best advice for entrepreneurs who are going to seek capital is to appreciate that it is like dating, but with a much lower likelihood of success.  Does that mean you shouldn’t try?  Of course not, but just understand that it is an activity that will tax your psyche and challenge your own sense of self-worth and happiness.  Get your helmet on and get out there, but be ready too!


Entrepreneurship is About Filling a Need – Inside the Entrepreneur

A statement I make regularly to my students is that entrepreneurs are focused on satisfying needs.  This is stated in connection with the basic requirement that a business needs customers.  And, in that context it is essentially important.  Frankly, I wish more entrepreneurs understood this when they started new businesses.  Recently, though, I have had some conversations with a few friends that have reminded me that entrepreneurship also often fills a more immediate need.  And, that is the need of the entrepreneur to succeed “to prove someone wrong.”

A few days ago I was talking about entrepreneurship with a good friend in the venture industry.  We were trying to identify the most important personality characteristic an entrepreneur could have.  Our conversation centered on the usual attributes – tenacity, self-awareness and risk assessment – but ended up fixing on something less often discussed. This was the entrepreneur’s motivation to succeed as a way to find completion or resolution of an unsatisfactory personal relationship or memory.  As my friend put it, he likes to back entrepreneurs that are motivated by a desire to “put it to someone.”  I was initially taken aback, but as I thought about this, and my own life experience, I realized that he had a good point.

The  illustrative story he told me was of an entrepreneur who shared that he could have gone to Harvard or Stanford, but went to a less well known university “because if he went to _______ he could get a scholarship and stop having to be [s—t upon] by his father.”  The entrepreneur (unwittingly perhaps) communicated something fundamental about his personality – a desire to be his own man, to be in charge, and perhaps to excel over the negativity of a parent.  My friend pointed out that this story was reflective of most of the founders that he has backed – they all share in some way a desire to overcome, or prove wrong, someone who was close to them along the way.

As I have reflected on this story, it seemed to me that there was something to it.  In my experience entrepreneurs are motivated by a desire to control the world around them, coupled with a belief and vision that they can do so.  It is a core value, and passion that drives all entrepreneurs that I know.  Could it be that what explains this desire for control with many entrepreneurs is a desire to obtain power so that they can be safe, or secure, or to fight back against someone who has harmed them?

I’ve rolled this thesis around with a number of successful entrepreneurs since that time.  Interestingly, all of them have in common a motivating event where someone told them they “weren’t good enough” or “would never amount to anything.”  In fact, in each case they have pointed to these events as change-making moments that are long remembered.  I have a similar story in my own life where a high school principal reminded me that while I thought I was as smart guy, “the world doesn’t give a [frack] about you.”  That guy pissed me off, let me tell you.  And, he motivated me for sure.  Another friend told me of an interview for a prestigious job where he got turned down after he was told by the interviewer he wouldn’t amount to anything in life and asked “if he was on drugs or alcohol.”  Apparently, he thinks about that interviewer often as he goes through life….

I have often remarked that the most important entrepreneurial characteristic is self-awareness.  That is still true to me – an entrepreneur must be able to calibrate information, data and experiences to change paths and adapt to changes in circumstances.  But, perhaps I have shortchanged the “why” of entrepreneurship?  What motivates and shapes an individual’s life ambition and career path to be an entrepreneur rather than employee?  Could it be that entrepreneurship is driven by a deep seeded need – the need to be right, to be powerful or successful?  Does ambition require a sense of inadequacy (at least for a time), to take root and drive us forward?  Can you be a happy and well-adjusted child and become an entrepreneur?

I don’t have an answer to this question today.  Perhaps you do, and will comment on this blog post.  But, I will say that I have been exposed to another tool for evaluating entrepreneurs to work with, and invest in.  In future due diligence meetings, I am likely to ask “Do you have what it takes” right before asking “Who has really pissed you off.”

An Investor Perspective: How Committed Should an Entrepreneur Be

Yesterday I read a posting in Facebook that was extremely critical of a local entrepreneur CEO who had committed to spend 4 hours a week acting as a mentor for other entrepreneurs.  The commentator was hard on the CEO, suggesting that a CEO who did something like this would not be backed by investors.  As I read this post, I was dismayed for a few reasons. First, I like the CEO personally and think he is a solid guy.  Second, I thought that the commentary was just wrong.  As an investor, I thought that it was timely for me to weigh in on the big issue that lurked behind the commentary – how committed should an entrepreneur be to his startup?

The place to begin is to acknowledge a few home truths. The first is that entrepreneurship, particularly, startup entrepreneurship is a 24/7 job.  It is not something that should be done lightly or without passion.  Successful entrepreneurs make their startup business their number one priority. This happens because of some of the key behavioral aspects of entrepreneurial behavior: passion for the entrepreneurial journey, optimism and a belief that an entrepreneur’s own efforts can change the surrounding world in a material way.   The net result of this is that successful entrepreneurs tend to give the appearance of monomania and single mindedness.

There is another aspect of entrepreneurial behavior that is not as widely discussed, and frankly should be.  Successful entrepreneurship also requires mental health.  It is extremely stressful to live on the edge, and manage the ambiguity of entrepreneurship.  Balancing this is the particular rush that comes with the journey, its highs and lows, and not knowing how it will turn out.  The very nature of the startup journey – its inherent instability – may be its most intoxicating characteristic. This explains why when entrepreneurs achieve an exit (or a failure) they tend not to retire to the beach, but find another startup.

The dark side of entrepreneurship, however, is that it also attracts personalities that are dysfunctional. The rush of entrepreneurship, and its intoxication, can fuel the flames of personality types that are ultimately fundamentally unsuited for business success.  Risk taking for its own stake, constant challenging of authority, a need for complete control, and the riding the highs and lows, may be examples of behaviors that manifest from dysfunctional and self-destructive personality flaws.  This is the largest challenge that investors face – determining the difference between someone who is drawn to the flame of startup life, but is able to manage not to be burned by it, and someone who will ultimately be consumed by the flame.

Personality is complex, and it eventually provides the template for how we deal with stress and challenges.  Individuals have something I call their “winning strategy” – the behavior pattern they utilize when they have their backs to the wall.  For example, people who are introverted tend to take challenges on by closing themselves in dark rooms and thinking.  People who are extroverted tend to want to talk things out.  For individuals under stress the largest issue to address is whether their winning strategy is in fact the best strategy for dealing with a challenge.

My experience with the startup CEOs that I have backed (and the many others I know well through FounderCorps and elsewhere) is that the most important characteristic that the successful ones all share is self-awareness.  This allows them to moderate and modify their personal winning strategy, or surround themselves with people who are able to work with the entrepreneur’s winning strategy appropriately.  In other words, functional entrepreneurs tend to be better able to see how their behavior patterns work with and affect their surroundings.

In my experience, self-aware people share another characteristic – they understand what steps they must take to nourish themselves.  The same way that we all need to eat, we all need to do things that allow our minds to rest and revive.  Successful entrepreneurs can identify the limitations of their personality, and find ways to take care of themselves for the long term.  Because entrepreneurship is a long term, life long journey.  It is a marathon, not a race.  Simply put, entrepreneurship is a 24/7 job, but entrepreneurs need to find ways to manage the stress and nourish themselves.

I am not suggesting that a startup entrepreneur shouldn’t have as his number one priority the success of his business.  Nor am I ascribing to the view that an entrepreneur’s life should be in balance the way that an employee’s should.  A true entrepreneur is 100 percent committed.  But, that is different from saying that an entrepreneur has to work on his startup every waking moment.  When I work with entrepreneurs I find that they are much more likely to be successful if they have some outlets and opportunities to refresh themselves.  The important thing is that they have sufficient perspective and self-awareness to take care of themselves.

In answer to the question, what do investors require from their founders I say that we look for, and require, a healthy and consistent commitment to the startup.  We look for perspective and self-awareness.  We are wary of compulsive people that are unaware of their behavior patterns and how it affects their surroundings.  In short, if a startup entrepreneur wants to spend 4 hours being a mentor, or 4 hours on a golf course, or 4 hours in a Church it is up to them. All I care about is the success of the business that I invest in.  And, I want the entrepreneur to be fresh, motivated and committed 100%.  How the entrepreneur accomplishes this task, is ultimately within their control. Because that my friends is the most important lesson of all. Entrepreneurs become entrepreneurs because they want to be in charge of their lives.  To suggest that they should confirm to a blanket truism or approach completely misses the point.