Resilience in the Storm

by mbmccall

Resilience is a key theme you will hear about time and time again in the entrepreneurial world. The ability to persevere and bounce back from adversity is part of the DNA of a successful entrepreneur (and VC Sith Lord). During the 1999-2002 period, nearly everyone in the venture and entrepreneurial world went through an historic resilience test. No business model seemed to work, corporations and consumers weren’t buying and Darwin was taking company after company into the grave. While I hope we never see times like these again, I do believe that we will have a downturn in the next two years. With many companies relying on advertising models to support their firms, they will learn how quickly a recession can dent this model.

I remember this period all too well. I remember seriously questioning what I was doing in the venture business where all I seemed to be doing was going to board meetings to discuss why our companies were missing budget, yet again, and how many staff could we lay off. I was working long hours, thinking that if I spent enough time at it, things had to get better…right? I lost 15 pounds from stress and lack of sleep.

During this period, I read a great article by Roger McNamee, one of the awesome investors in the business (he is currently partnered with Bono and the former CEO of EA on a media fund, Elevation Partners).  He said that in times of massive macro change, there is little you can do as an individual to change your environment. You can respond by, like Homer, lashing yourself to the mast, and screaming at the on-coming storm. Or, you can use the time to truly understand what is important in your life…family and friends. In fact, he advocated that you will have limited influence on outcomes during macro setbacks, and that these are prime times to increase the amount of time you spend with your spouse and kids.

In short, his framework seemed to be: there are things that you have limited control over and that are fleeting (success at work, social standing, etc) and there are things you have considerable control over (your friendships, your relationships with your kids and wife, etc). Which do you want to tie your image of self and your happiness to? What do you want to look back at and remember that you did?

My response was to start having weekly lunches with my son at his elementary school and taking my daughter to school in the morning. I signed up to coach baseball with them. I spent more effort trying to have dinner with my family and to keep in touch with my friends. Not only did it significantly increase my resilience, but it instilled a different set of operating principles that I still use today. So, my advice to all entrepreneurs is to figure out what is your core foundation, that which is essential to you and which you have some degree of control over. Once you have, connect with it, protect it and use it to keep the rest of your life in perspective. Unleash the mast…

The People’s Voice

by mbmccall

It is too late for me to get a full post out, though I have several topics on the burner. That said, I would be interested in hearing from you (either in the comments section below or email: mccall@dfjportage.com) about a) topics that would be of interest to you and b) ideas/suggestions about how to make this blog more interactive or engaging. This blog will only be as useful and successful as it is relevant. Love to hear your voices…

The Black Art of Deal Pricing

by mbmccall

Summary:
— pricing is driven off of multiples not IRR
— VC’s target 10x due to high failure rates
— start at the expected final valuation and work backwards.

What area of venture capital is more opaque and mysterious than how VC’s price deals? Professors have tried to quantify and analyze what we do. Ironically, it is quite simple, though subjective.

Many entrepreneurs try to approach valuation from a classical discounted cash flow model. They show what the next 5 years are going to look like and then discount it back to the present using various discount factors. If you are going to pitch a VC, please don’t use this methodology as you will start your relationship there with a mark against you (also, don’t claim a) your numbers are conservative…trust me, they are optimistic at best and b) you have no competitors…you need to do more homework).

The core issue is that the venture business is unpredictable. Numbers going out more than a quarter are unruly. Those going out 5 years are pure fantasy. Market adoption rates, pricing models, product mix and such are all up in the air. Therefore, the numbers are useless and the DCF from them are even more so. Furthermore, good luck trying to nail down what the right discount rate is…lot of beta in this business.

The venture business is driven off of multiples. Early stage VC’s target 10x return of capital and expansion/late stage investors target 3-5x. Why 10x…seems a bit usurious? The classic venture portfolio looks like this. Of ten deals done:
— 4 crater
— 2 are breakeven +/- a little
— 3 are 2-5x capital
— 1 is 8-10x

So, as a VC, you hope that all 10 deals will be the next Microsoft, but reality sets in at the first board meeting. You need to target 10x for your winners in order to pay for the losses elsewhere.

VC’s will then try to estimate a) what they think the company might be worth if successful in 3-5 years and b) how much more capital will be needed. In a simple case, let’s assume that the company is worth $100m in 4 years and will not take additional capital. Using the 10x rule, the VC will price the deal so that post-$ valuation of the deal is $10m. If the company is raising $2M and adds $1M worth of options to its pool, the VC will pay $7M pre-$.

Clearly, the Achilles heel here is how to estimate the terminal value. I have seen several reports indicating the average IPO (only about 10% of exits these days) has had an $180m valuation and the average M&A valuation is around $120m (about 90% of exits). This puts the average overall around $125-130m. Assuming no new capital (big assumption) and an average raise of $3-5m, this would put your average pre-$ around $7-9m. Seed deals will usually price between $2-4m pre-$.

There is lot of variance in these numbers, so use them more as examples to help you understand the black, Voodoo art of VC pricing.

World Is Flat part II

by mbmccall

In yet another indication of how global the entrepreneurial world is becoming, our portfolio company, Imago, just acquired its primary competitor, an English company, while selling nearly half of its machines in Asia and Europe. Imago sells a mulit-million dollar 3-D atomic probe (atomic microscope).  (Congratulations Tim & team!)

Following up on yesterday’s post, when the day ended, people from over 80 cites had hit various posts with well over half coming from Europe and Asia.  You see this in online gaming where kids in Winnetka are playing against counterparts in Korea and China. Exciting times.

In the 1980’s, you could be the best regional company, selling your software, service or infrastructure into your area like the Midwest or California. In the 1990’s, the business became much more national in scope and now, it truly is a global marketplace. While this opens up large markets, it also adds complexity in managing your business. Clearly, as has been written extensively, the internet is only going to make this more so going forward. It will be interesting see if our friends in Washington push for a solution that drives the US to be a more competitive country (school reform, infrastructure, etc) or more towards protectionism. We will see…

World Is Flat

by mbmccall

Here is another supporting fact about our how flat our world truly has become. I use Blogbeat (thanks to Brad Feld’s suggestion) to analyze site traffic. Here is the "City Cloud", listing where visitors to my site came from since last night at Midnight until 8am today (the bigger the letter, the more traffic from that city). Pretty wild:

            Ajax Alameda BeijingBrussel
Budapest
Chicago  Geneva Hangzhou Jinan Los Angeles
Madison
  Nanjing
   Obando
 Perth
  Praha
 Raleigh
    Riyadh
  Shanghai
      Sherman Oaks
   Sunnyvale
  Tallinn
  Ultimo
Wilmette

Affluenza Outbreak

by mbmccall

Scott Burkett and I have been blogging back and forth about the importance of giving back, the power of small groups and the need for philanthropy. His most recent post, Philanthropic Entrepreneurship: Up Close talks about an entrepreneur in Atlanta, Tom Flaim, and his brother who started a not-for-profit company, First Wate Systems, to provide a variety of solar-powered water purification systems for the developing world and domestic emergency management. I am a firm believer of letting a thousand flowers bloom. I think that the ills of our society are best addressed by small groups targetting very specific issues (clearly with public policy support). This means any and all of us doing whatever little we can. Scott has a great Margaret Meade quote:  "Never doubt that a small group of thoughtful, committed citizens can
change the world. Indeed, it is the only thing that ever has."

I live in Winnetka, an affluent suburb of Chicago. Diversity entails having brown and blonde haired children and poverty consists of kids not getting the latest PSP game. Like all parents, I love my kids and seek to give them every advantage possible. This plays out in suburb and city after city in the US. Unwittingly, despite our best intentions, we are infecting our kids with affluenza. Wikipedia defines this as:
"The American middle class [and wealthy] is often criticized for never being
satisfied. People are constantly wanting new things and are never
satisfied with what they have. Affluenza ties into the criticisms that
there is a superabundance of popular culture and such."

Schwab’s website has an article that goes as far as to say: "Part of the problem is that many parents are oblivious to the messages
they unwittingly send their kids: that desires are simply there to be
gratified; that status and luxury are birthrights."

Is there an antidote? It grows more challenging each day to impress on our kids (and ourselves) about the effects of affluenza. We each deal with it in our own way. My wife and I are trying to get our kids exposed to other communities and to social causes early on, but it is not easy.

However, the global poverty numbers are staggering. While there are various estimates, one puts the number of people living on $2/day or less at 2.6 billion. That is roughly 9 times the population of the US. Other statistics:

Number of children in the world
2.2 billion
Number in poverty
1 billion (every second child)
Shelter, safe water and health
For the 1.9 billion children from the developing world, there are:
  • 640 million without adequate shelter (1 in 3)
  • 400 million with no access to safe water (1 in 5)
  • 270 million with no access to health services (1 in 7)
Children out of education worldwide
121 million
Survival for children Worldwide,
  • 10.6 million died in 2003 before they reached the age of 5 (same as children population in France, Germany, Greece and Italy)
  • 1.4 million die each year from lack of access to safe drinking water and adequate sanitation
Health of children Worldwide,
  • 2.2 million children die each year because they are not immunized
  • 15 million children orphaned due to HIV/AIDS (similar to the total children population in Germany or United Kingdom)

Makes one think and wonder…

The Sexy Art of Entity Formation

by mbmccall

No venture blog is complete without at least one post on the debate about what legal structure to use in launching your business. However, I have a little help (and will cheat a little) since I am attaching Jack Levin’s presentation on the subject to this post. I was on a panel this Saturday at Northwestern’s Law School with Jack and Randy Kaplan, co-founder of Akamai. Jack  is the senior Private Equity partner at Kirkland & Ellis and the dean of corporate law in this space. I highly recommend getting a chance to listen to him if you ever get the chance. At a very high level (and doing a disservice to the topics), here are some quick takeaways. I would recommend looking at the attached presentation for more detail Download nwu_entre_conf_406.ppt

.

1) In forming a company, make certain that you have formed it sufficiently before any capital comes into the company. If not, the new capital will place a value on the firm and, by definition, on your share of the business. In a worst case scenario, if you form the company in conjunction with a financing, you will owe tax (section 83) on the value of your share of the business. New investors can leverage preferred securities to take some of the bite out of this valuation, but the longer the time between formation and funding, the better.

2) Entrepreneurs generally have three primary choices for the legal entity of their firm: S Corporation, C Corporation or LLC (each is hyperlinked to their Wikipedia definitions below).
— C Corp is the structure of choice from an institutional investor perspective. If you are are going to be taking professional capital, you will most likely be "encouraged" to convert to a C Corp. Institutional investors often have tax-exempt investors. UBTI (unrelated business taxable income), which can often be triggered in a business, will flow through pass-thru entities like an LLC or Sub S Corp to these investors, requiring them to file a tax return on this income. There are many articles on UBTI such as the Drinker Biddle post for more information. The primary issue with C Corps is that you incur double taxation on both income and at sale. As a result, you only want to use this structure if you are considering near-term institutional capital.
— S Corp is a pass-through entity that enjoys the liability protection of a C Corp while avoiding the double taxation issue. However, it is limited to 100 shareholders, does not allow for different classes of equity (e.g. preferred stock) and does not allow corporate or partnership entities to be shareholders. Jack’s main criticism of S Corp’s is that they are fragile in the sense that they can be blown (often converting automatically to a C Corp often) by a multitude of issues. S Corps also have various burdens that LLC’s do not including by-laws, boards, minutes, etc.
— LLC is a pass-through entity (limited liability entity) that also enjoys liability protection while enjoying single taxation. It allows for multiple classes of stock and has a more flexible management structure. However, few institutional investors will invest in an LLC and converting them to a C Corp requires more effort than an S Corp. People are least familiar with this entity, including employees (stock versus membership units).

In short, if you are not expecting to raise institutional capital, you are best off using an LLC or S Corp (preferably the former). If you are looking, in the near-term to raise PE money, then you should consider coming out of the blocks with a C Corp. Some firms have raised PE capital from an LLC structure, but it makes your fundraising efforts significantly more difficult due to PE investors’ biases against it.

Jobs/Wozniak Setbacks and other Stories

by mbmccall

My wife just bought a book for our kids by Steve Young (the motivational guy, not the quarterback) titled "Great Failures of the Extremely Successful". It is a mixture of inspirational quotes, short snippets and essays from famous people who have overcome adversity. For entrepreneurs dealing with the day to day challenges and setbacks of building the next Microsoft, it is a good read.

Some of the quotes I liked:
"You don’t drown by falling in the water;
  You drown by staying there." — Edwin Louis Cole

"What is easily achieved or acquired seems not to be long lasting while what is more difficult to achieve is more worthwhile and enduring" — John Wooden, UCLA basketball coach w/10 NCAA titles

Snippet:
For those looking for funding, just remember…
"So we went to Atari and said, ‘Hey, we’ve got this amazing thing, even built with some of your parts, and what do you think about funding us? Or we’ll give it to you. We just want to do it. Pay our salary, we’ll come work for you.’  And they said,’No.’  So, we went to Hewlett-Packard, and they said, ‘Hey, we don’t need you. You haven’t got through college yet.’"
— Apple Computer Inc. founder Steve Jobs on attempts to get Atari and HP interested in his and Steve Wozniak’s personal computer

…and the classic
Failed in business in 1831
Defeated for legislature in 1832
Second business failure in 1833
Suffered nervous breakdown in 1836
Defeated for Speaker in 1838
Defeated for Elector in 1840
Defeated for Congress in 1843
Defeated for Congress in 1848
Defeated for Senate in 1855
Defeated for Vice President in 1856
Defeated for Senate in 1858
Elected President of the US in 1860

Horse or Jockey?

by mbmccall

There is much discussion in the venture business about whether you back the horse or the jockey. Some, like Don Valentine at Sequoia, state they look for large growing markets and find the team later. More frequently, you hear VC’s saying that the business is about people, people, people.  In the end, I would argue (conveniently) that it is both. Market readiness makes heroes and fools out of investors (right concept, wrong decade). If the market/customer base is not ready to adopt a technology or solution, for whatever reason, even the best management team will be unable to win. That said, management teams are critical to success in the race. Often, when the market is ready, the trophy normally goes to the team that out-executes the rest. Just look at Google versus Alta Vista, Ask Jeeves and Inktomi. Of these two, market (horse) has the greatest macro impact but management (jockey) has the greatest micro impact.

Warren Buffett, the largest cheerleader for backing good managers, once said however:
“When a management team with a reputation for brilliance tackles a business with a reputation for bad economics, it is the reputation of the business that remains intact.”

Along this line, Prof Steve Kaplan, from the University of Chicago, recently gave a great presentation at the IVCA annual lunch about Horse vs. Jockey, including some fascinating statistics and analysis. He clearly comes down on the Horse side of the arguement.  I highly recommend reading the attached PPT file of it. Download kaplan_horse_jockey_april_2006.pdf

Eric Schmidt Unplugged

by mbmccall

Eric Schmidt spoke tonight to a packed crowd at the Economic Club. He talked about how Google views the world and what they hope to do in the coming years. Overall, it was a fairly interesting speech. Key points included:
— We live in a world of continuous distraction and multi-tasking. Just look at kids doing IM, watching video, talking to friends while doing homework. It will only get worse.
— People’s attention is the most important asset for marketers (similar in theme of the AttentionTrust initiative).
— The key to getting people’s attention is targetted advertising instead of untargetted. He asked how many people read the paper this morning or watched TV. Could they recall any ads they saw?
— Society is trying to block untargetted ads with Tivo, spam filters, Do Not call lists and such.
— Social communities will become more and more core to interactions and marketing on the web.
— An example of a social paradox: people lonely in the city.
— Group dynamics, such as predictive markets (future blog), are fascinating
— Study after study shows that groups collectively predicting/assessing dramatically outperform individual experts. How to tap? Some hedge funds trying to find ways to mine opinion from chat rooms about stocks. The trick is guaranteeing no gaming…one person, one vote.
— He said that all decisions at Google are made consensually through groups. New ideas are broken out into three person teams.
— Predators, Phishers and other such elements are greatest threat and will always be there.
— Google is working on auto-translation products. This will allow content, trapped within a language such as Japanese, to be freed for consumption world wide by all.
— Not only is the world opening up as never before, but data is unbounded as well, with handhelds having access to all content in the world. Google mobile core to this.
— Furthermore, handhelds will truly be digital assistants. They will know location & preferences in order to deliver what you want, when you want and now where you want.
— We are at the early stages here. Over 1 billion people are online, but 5 billion are not (of course 2.6 billion people get by on less than $2/day).

He took a few questions, including ones about their China interaction. How can they "do no evil" while also complying with censorship in China? He said that they want to be a part of every country’s engagement of the internet. They have to respect (though not agree with) the laws of each country.

In short, Google’s goal is to help people organize and find all information in the world, whether online or offline. Feel the fear…

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