Art of the Start: Recession Style

by mbmccall

Guy Kawasaki has a great post on the things to focus on in tight financial markets when launching your business in his post "The Art of Bootstrapping". It has a number of common sense suggestions for entrepreneurs:

"Too much money is worse than too little for most organizations—not that
I wouldn’t like to run a Super Bowl commercial someday. Until that day
comes, the key to success for most organizations is bootstrapping. The
term bootstrapping comes from the German legend of Baron von
Munchhausen pulling himself out of the sea by pulling on his own
bootstraps. That’s essentially what you’ll have to do, too….

Forecast from the bottom up. Most entrepreneurs do a
top-down forecast: There are 150 million cars in America. It sure seems
reasonable that we can get a mere 1 percent of car owners to install
our satellite radio systems. That’s 1.5 million systems in the first
year. The bottom-up forecast goes like this: We can open up ten
installation facilities in the first year. On an average day, each can
install ten systems. So our first year sales will be 10 facilities x 10
systems x 240 days = 24,000 satellite radio systems. That’s a long way
from the conservative…"

Fifteen Year Cycle

by mbmccall

As the bad news keeps pouring in, a lot of people are wondering what we can expect in the coming years. Additionally, everyone is trying to figure out what hope exists. Well, I’ll give two thoughts on this (briefly).

First, the world of technology is driven by two factors: the laws of exponentials and the Black Swan. Progress does not occur linearly but exponentially. We can expect to see changes the magnitude of the past 100 years in just the next 20 years. This means a lot of people are going to a) be really busy and b) be dramatically better off. These changes will come from places you can’t predict (Black Swans). Market crashes and negative developments are not the only unexpected six sigma events.

Second, markets run in roughly 7 years cycles and technology in 15 year waves. Vacuum tubes to main frames to mini-computers (DEC) to PC’s (Apple/Microsoft) to the Internet. The next wave, then, should start in 2010-11 and hit full force in 2015-16. Many in the business (us, Kleiner, etc) feel this will be in Cleantech. The energy market is 10-20x the IT market. We are not talking about billion dollar markets but trillion dollar ones. There will be a lot of casualties but some enormous wins.

So, there us no doubt that life is really brutal today. But, prepare and get ready for enormous, explosive market opportunities. It’s going to be mindblowing.

So, I stick my neck out again typing on my small iPhone. I declared the old venture cycle dead last June. I am declaring the the next cycle, even bigger than the former, will kick in during 2010 with foundations forming by the end of next year. I also believe we will see 30-40% of remaining venture firms will not survive to see this through (food for another post)…

Ignorance and Humility

by mbmccall

"I am the wisest man alive, for I know one thing, and that is that I know nothing."
                                                            — Socrates

I was very pleased with myself. Through early October, on my person investing outside of venture, I was actually up nearly 3% for the year. My shorts had held, gold was acting as an insurance, I had gone to cash sufficiently early. I clearly had figured out how to manage the markets in turbulent times and was even getting good at forecasting. This illusion shattered in the following three weeks. It always happens when I (or others) become complacent, overconfident and convinced that my good fortune is due to my genius and will continue on linearly.  I took my shorts off prematurely, Gold started to drop with the market (depression concerns) and my proudly purchased 4 P/E stocks dropped in a matter of days to 3 P/E stocks. I tried to put the hedges back on just as the market would jump back up and remove them just as they would go back down, knowing full well of each investment rule I was violating. Suddenly, I was 10% down in just 7 days. Whoops…

This just goes to show how important it is to keep ones discipline in both good times and bad as well as a balanced view on both the up & down sides. There are a lot of people who have lost a lot of money (or are losing their companies now) because they lost discipline during the good times. For VC's, this is momentum investing, paying up for rounds, expecting someone else to pay an even crazier amount. For entrepreneurs, this is allowing your burn to grow and focusing on too many things. Then there are those losing money on the downside and we all have more than enough examples there.

James Montier, from Societe General, recently wrote an interesting piece on the beauty of Ignorance and Humility.   Click here to download Montier_Ignorance.pdf. In it, he discusses the need for acknowledging ignorance and our inability to forecast the future as well as the importance, therefore, of staying humble while sticking to the fundamentals of a business. This is the key insurance policy you have in these times. It's a good read.

If Larry and Sergey Asked for a Loan …

by mbmccall

"Be fearful when others are greedy, and be greedy when others are fearful."
            — Warren Buffett

Well, there is no doubt that fear is running rampant through the streets. This will provide a great opportunity for entrepreneurs to take advantage of market inefficiencies not seen for decades. Those that intelligently manage the downside, will be well positioned for significant future upside. We call this asymmetrical risk. The key is to respect the global forces impacting our economy without letting it paralyze you. I like Friedman's distinction between risk-taking and recklessness. The former is rewarded highly and later punished severely.

Thomas Friedman had an interesting recent op-ed that Whitney Tilson recently commented on.

The hardest thing about analyzing the Bush administration is this: Some
things are true even if George Bush believes them.

Therefore, sifting through all his steps and missteps, at home and abroad,
and trying to sort out what is crazy and what might actually be true — even
though George Bush believes it — presents an enormous challenge, particularly
amid this economic crisis.

I felt that very strongly when listening to President Bush and Treasury
Secretary Hank Paulson announce that the government was going to become a
significant shareholder in the country’s major banks. Both Bush and Paulson
were visibly reluctant to be taking this step. It would be easy to scoff at
them and say: “What do you expect from a couple of capitalists who hate any
kind of government intervention in the market?”

But we should reflect on their reluctance. There may be an important
message in their grimaces. The government had to
step in and shore up the balance sheets of our major banks. But the question I
am asking myself, and I think Paulson and Bush were asking themselves, is
this: “What will this government intervention do to the risk-taking that is at
the heart of capitalism?”

There is a fine line between risk-taking and recklessness. Risk-taking
drives innovation; recklessness drives over a cliff. In recent years, we had
way too much of the latter. We are paying a huge price for that, and we need a
correction. But how do we do that without becoming so risk-averse that
start-ups and emerging economies can’t get capital because banks with the
government as a shareholder become exceedingly
cautious.

Now is one of the worst time to become risk-averse…just be intelligent about it.

Be Careful Who You Deal With

by mbmccall

As these markets continue their chaotic path downward, people's true colors come out. Some people show increasing amounts of fairness and consideration. Others will self-optimize and use every bit of leverage that they can get their hands on.

Two entrepreneur friends of mine recently had a very negative experience with an investor who has a reputation for being Machiavellian and it really, really has incensed me.  These slimy bottom suckers use the changing market conditions to test how low they can retrade an existing deal.  Here is the standard game plan for these kinds of assholes. When they sense a dramatic change in the market, they pull away their term sheet siting "policy" changes. However, instead of walking away from the deal, they mention in passing that they might reconsider under "different terms". If the entrepreneur bites, they know that they have leverage and they proceed to throw down absolutely egregious terms (multiple liquidation preference, half the original price, etc). If the entrepreneur bites on this, they know they really have them and continue to ratchet down the terms until things break and they back off.

Entrepreneurs who have a retrade occur, must first figure out how badly they need the money. If they can get the runway from expense cuts or manage to breakeven, then they should tell the investor to pound sand as soon as they mention "different terms". Remember, even if you get this round done, you will be stuck with this scum for years to come and any time things go the wrong way, they will use their leverage to take another pound of flesh. This falls into my category of "Life is too short to deal with Assholes". If you have to take the money, negotiate as hard as you can, realizing that they will continue the downward ratchet. Try to drag out discussions and aggressively start talking to any other possible sources, even if under the same terms (if you think they are decent people, at least the match won't burn twice).

Before dealing with someone, especially an investor, find out what their reputation is in ugly situations. Did they roll up their sleeves and help the CEO or did they use the situation for leverage to self-optimize. Animals don't change stripes so assume you will see more of the same with yourself.

If I wasn't concerned about libel issues, I would list a couple of these known predators (with details) such as the one pimping my friends. I can only hope that the Laws of Karma eventually return the favor…

What Compensation Should You Give Your Team?

by mbmccall

One of the most popular search topics on my blog has always been compensation. I thought I would lay out historically the average benchmarks with some caveats. The first caveat is that these numbers will be skewed more towards an early/expansion stage company versus a start-up or late stage companies. The second is that with conditions worsening, a lot of companies are going to need to ask employees to take across the board pay cuts (usually in exchange for some equity) to stretch the runway out. The third is that these are non-founders stats. Founders will have much higher equity and lower salary. The fourth is that each situation is different, as is each employee, so there are trade-offs between salary and equity. That said:

CEO (non-founder)
Salary $180-200k, bonus $50k+, equity around 5-7%

CMO
Salary $150-175k, bonus $50-75k, equity around 2%

COO/CFO
Salary $150-$175k, bonus $50k, equity 1-1.5%

VP, Sales
Salary $150k, bonus tied to sales (usually in the $50-75k+ range), equity of 1-2%

Other VP spots
Salary $140-150k, bonus $25-50k, equity 0.75-1%

Director and below
The market will dictate these. Directors usually in the $110-130k range, key programmers in the $90-120k range, controller in the $50-80k range depending on experience.

Again, these are very rough cuts. For example, a rock star CEO could easily end up at $225-$250k, $75-100k bonus. Also, I can't emphasize enough that in this current cycle, having runway (target at least 18-24 months, 12 months minimum) is your key lifeline. If you are not there, you need to sit your team down and discuss an across the board pay cut (with equity bonus tied to goals). You need to do this now so that the company has a number of months of benefit from it to stretch out the runway. Firms almost always wait too long, hoping that things will turn, and start efforts like pay cuts with only a couple of months to go. This does little to impact the runway as you have too few pay periods of savings.

Just remember: I have never (yes, never) heard a CEO bemoaning the fact that he/she reduced his/her burn too soon. I have frequently heard them comment that they wish they had done so 6-8 months earlier.

Hate to Say I Told You So…

by mbmccall

Back in June of this year, I did a post called Rough Ride Ahead: Buckle Up & Get Your Money Now (if you can). My words of advice were:

"If you are close on terms with an
investor, do what you need to get it closed now. If you have access to
capital, draw it down and don't touch it as it may need to last a
while. If you have a high burn rate, you had best start aggressively
cutting it now. If you are going into this cycle burning $1m/mo, you
will have no ownership left by the time the cycle turns up and if you
are burning more than $500k/mo, your cap structure is going to take a
hit if things turn out as badly as I fear. In these kinds of times,
breakeven is great (wait out the competition) and $100-200k/mo burn is
manageable."

Well, things have hit full force and all of the VC's are panicked over the dire situations facing their portfolio companies. Above is a proxy for what most are saying now four months later. Why the sudden sense of urgency? Hasn't this venture market been basically dead for the past couple of months? I can only assume that the market crash has dimmed whatever hope that an upturn was around the corner.

To understand better why the Valley is sweating bullets right now, you have to understand the context of their portfolios. For the past two years, the Valley has felt very confident. They have been investing in an array of companies at crazy high valuations that, in many cases, had not figured out their revenue models. As LP's pushed and shoved into these funds, groups have been able to raise funds roughly every two years. In addition, because they have twice the size of older normal funds, they have added partners and now put twice as many deals into each fund (40+ vs 20+). Lastly, these funds, since 2003, have only had 10-20% realizations.

So, the average branded Valley firm has probably 3 recent funds (and several legacy ones) say in 2003, 2005 and 2007. Each one has 40+ deals and only 8+ exits. So, they have nearly 100 existing portfolio companies plus whatever legacy deals are around going into this down cycle. Follow-on financings have become very difficult and other VC's are getting very predatory in their negotiations. With probably north of 120 children to take care of each, you can see why the Valley is not very happy right now.

This is going to get 2001 ugly for those firms unable to cut burn, grow revenue and get to breakeven. VC's are going to be in triage mode and more likely to let the truly wounded investments go. You entrepreneurs will need to take control of your own destinies or Darwin will do it for you.

In case you are curious what the Valley is advising firms to do, below are the links to several of the more popular VC communications to entrepreneurs about this down draft. Enjoy…

Sequoia's R.I.P to Good Times Presentation
Ron Conway's Email on the Meltdown
Benchmark's Gurley Email to Portfolio Companies

What Are Some of the Hedge Guys Doing Now?

by mbmccall

After the downdrafts, you would assume that people would be jumping into market to bottom feed. However, a number of the smartest guys have massive cash positions. Clearly, they are waiting for the other shoe to drop. From a recent Whitney Tilson piece:
"These are smart guys, but I
think they're wrong here — and think that this is extremely
bullish:

Some hedge-fund titans have yanked most of their money out of the stock
market, a bearish sign amid Monday's euphoria and an indication of how the
hedge-fund business is changing amid chaos.

In recent days, Steven Cohen, the hedge-fund manager who runs the $14
billion SAC Capital Advisors, moved about half his funds, or about $7 billion,
into money-market and other short-term securities, eliminating much of his
fund's exposure to the stock market, says a person close to the fund. Mr.
Cohen plans on sitting on the sidelines for the rest of the year — trading a
small portfolio himself but keeping shuttered most of the stock portfolios of
his other managers.

Israel Englander, who runs the $14 billion Millennium Partners fund, has
shifted about $6 billion from the stock market into cash, a person close to
the fund says.

Meanwhile, John Paulson, manager of $35 billion Paulson & Co. — who
made a spectacularly successful bet against the housing market last year —
has much of his fund in cash equivalents.

The retrenchment by Wall Street's "smart money" crowd is part of a larger
effort by hedge funds that have put a total of as much as $400 billion into
cash equivalents recently, according to David Kostin, an analyst at Goldman
Sachs Group Inc.

Of course, much of the smart money has been wrong in the credit crisis.
Many hedge funds have lost big money in the past year. That said, Messrs.
Paulson, Cohen and Englander have fared better than most: Mr. Paulson's main
fund is up about 20% this year; Mr. Englander's main fund is down 0.5%; and
Mr. Cohen's main fund is down more than 9% through September. This compares
with a 29% loss in the Dow Jones Industrial Average, year to
date."

…Like An Oversexed Guy in a Brothel (Buffett)

by mbmccall

"Wall Street," reads the sinister old gag, "is a street with a river
at one end and a graveyard at the other." This is striking, but
incomplete. It omits the kindergarten in the middle.

Frederick Schwed, Jr., Where Are the Customer's Yachts?

Some of you may fear that I have jumped feet first into the Prozac laden, Doom & Gloom crowd. I am actually just the opposite right now. We have spent much of the past two years getting liquidity in our portfolio so, unlike 1999, we are going into this down draft with a light number of existing investments to navigate through these troubled waters. I am actually looking forward to finding our next generation of successful investments.

There are a couple of areas that do well in these  kinds of markets.  The most obvious are those solutions that eliminate distinct & meaningful chunks of expenses from companies's income statements. "Productivity" savings with secondary benefits don't count. This means that there was an expense before (credit card fee or brokerage fee or inventory cost) and now its gone. You will find very willing buyers if it is clear cut and does not require lengthy or expensive implementations or retraining.

Performance based revenue models also excel in these times. Customers have little spare capital to spend so they don't want to use it with the "hope" that they will get something back. If your proposition is that you get paid when they get paid, companies will view this as significantly less risky and much more acceptable. Also, if you are in the customer acquisition world, these can be gravy days as acquisition costs (advertising, search, etc) grow cheaper by the day.

There are an array of other models but these are two clear, classic ones for these times. Our company, Performics, doubled business every year throughout the tech bubble and crash. It was one of the leading performance based marketing firms in the US and now owned by Google.

So, while everyone is either dispondent (last week) or manic (this week), you should focus on business models that work in times of low budgets and exceptionally skeptical buyers. Nod your head to all of these horror stories and build up your business quietly in the background. It is the best of times and the worst of times.

Just remember: "If you're gonna panic, do it early." –Peter Lynch
Click here for other funny & interesting Wall Street quotes collected by Michael Ross

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