3 posts categorized "March 2009"

Aligning Management and Investor Incentives

    In bullet form below are some quick observations, here at the end of Q1 2009, on how different ventures in the “emerging company” category are dealing with the problem of management perceiving no equity upside to their efforts (and I’m not really discussing founders or startups here; that is another topic).  The common problem, to state it succinctly, is that current funding rounds are so dilutive, liquidation preferences are so high, and M&A values are currently perceived to be so modest, that only the investors (or the last round in) appear to have the prospect for positive returns.

  • In VC-backed companies, incentive plans are proliferating that promise management teams a significant (but typically single-percentage-digit) slice of sale-of-the-company proceeds, either off the top or just prior to investors with the senior equity preference.
  • In privately-held companies,* boards are taking advantage of significantly lower valuations to make restricted stock grants to key management, looking to motivate long-term service and performance with the prospect of meaningful dividend income as businesses generate profits; early exit scenarios may still need to be addressed with VC-like change-in-control incentive plans.
  • Equity or equity-like plans in general do not go as deep into company management as they might have previously.
  • Option grants under legacy option plans remain on cap tables, but decreased valuations are not driving new rounds of grants as they would have in the 90’s.
  • Option plans remain viable for certain startups, depending somewhat on the culture and the history of the founders, but broad-based participation winds down very quickly (measured in months, perhaps, rather than years).

*Yes, I do mean to imply that VC-backed companies are not truly privately-held; more on that later, perhaps.

Financial Regulation of the Venture Capital Industry

Just posted a comment to an interesting article from earlier this week on TechFlash about whether Geithner's proposal to further regulate the financial industry may extend to venture capital.  It seems to me that some consideration should be given to how the venture capital industry might change in the future, perhaps as the consequence of increased transparency in other layers of the investment ecosystem.

What, No Exit?!?

Some of you who follow my tweets have already heard me comment on a lunch I had a couple of months back, with two long-standing friends who are the savviest financial guys I know.   I went to that lunch with a mission:  to plumb their views on what the implosion in the financial markets means for entrepreneurs and companies, like my clients, who are going to need financing of one stripe or other in the natural order of scaling and expanding new ventures. 

My friends were ready for me.  In fact, they were ahead of me, far into envisioning a "next" investment paradigm.

"Bill," said Friend 47 (the age we have in common, shared also, incidentally, with the President and with George Clooney), "it's a mistake to think that what is happening now is a blip.  This recession is not a blip.  2001 was not a blip.  It's difficult for guys like you and me to see this right away, because our entire careers have taken place in one giant two-decade long blip."

"Too much," rejoined Friend S.O. (for "somewhat older"), "has been predicated on financial machinations divorced from fundamentals of operating profitable businesses."  Both he and Friend 47 went on to describe an investment paradigm that involved annual ROI, without the predicate that the investor would need or even desire a liquidity event. 

"If you invest wisely in real opportunities, manage costs and leverage efficiencies, are quick to cut off initiatives that prove not to generate returns, and you do it all in a way that returns everyone's invested capital over five to ten years, then throws off a dividend indefinitely after that . . . why would you want to sell it, unless you had another place to put the capital that would give you a better return?"  They went on to describe what they called a "partnership" model, where investors own and operate the business alongside management.  In this model, insiders are not selling the next guy on the rosy future of the business; instead, they are selling customers on the merits of the product or service.  In terms of future financing, the owners are also the only buyers for their own spin: they would only continue funding the company if they could convince themselves that the risks were merited by the potential returns.  Exits could happen, but they would be opportunistic; if strategic buyers wanted to take you out because they attributed more value to the business than the cash flow you were expecting, that might be fine.  But you would go into the business fully expecting to operate it.

In this view, someone like Madoff is not an outlier, but is instead emblematic of the normative investment paradigm of the past two decades:  the whole structure was a ponzi scheme.  In terms of tech ventures, it went like this:  angels seeded the next cool thing, hoping they wouldn't get too squashed by professional VCs who took the handoff and validated it; VCs in turn shopped the "deal" (diction betrays everything in the end, doesn't it; not the "business" but the "deal") to the mezzanine players; and then finally the company was flipped to the public, who in the hay-days of all of this were not unsuspecting so much as thrilled to be finally "let in."  With audacious (if ultimately unsustainable) use of leverage, the life-cycle was repeated for years (whole careers, even).

Friend S.O. is half way into the raising of a new fund which will look to buy businesses to operate, for the purpose of generating cash year over year.  Given the government's current attempts to pump liquidity into a frozen system, which would appear to entail the risk of hyper-inflation, this strikes me as a good hedge, from an investor's point of view:  why not have an asset that sells products or services at prices set in the denominations of future currencies?

The company founders and other early stage entrepreneurs I work with are of different minds on the implications of all of this.  Some are still highly motivated by the goal of a liquidity event, an exit that will let you mark the experience, tell the story, and maybe take some chips off the table to seed the next venture (I almost used the word "deal" there).  Others, already highly skeptical of traditional venture capital models, are warming to the idea that partnering with investors who aim to build profitable operations is sounder than committing to a pre-determined exit. 

The proof of the new paradigm's validity may be in designing equity, control and cash distribution models adequate to the task of motivating both founders and investors.  It probably won't be enough to simply desire to opt out of the "ponzi scheme" model.

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