A number of articles have started to appear that shine a harsh light on the mezzanine merchant bank groups like Advanced Equities. These groups specialize in raising capital for later stage venture companies. These firms have formed strong relationships with various brand name venture groups and help them raise "pre-IPO" capital for their businesses. These include companies like Vonage and Alien Technologies. The groups include the likes of Kleiner Perkins and NEA.

Ron May recently wrote in his May Report:

"Let me get specific…The case against Dwight and Keith (Advanced Equities) is that they are kissing up to the VC
firms and at the same time screwing over their retail clients. By the
way, they also sell some stock to institutions but the institutions are
more resistant to their highly inflated valuations. The VCs make out
like bandits and the retail investors that AEI sells to scrape for the
crumbs."

The standard procedure is that they find a company with a lot of buzz that has the momentum to potentially go public. These rounds carry extremely expensive valuations but are justified by being priced at a discount to a likely, near-term IPO. These were all the rage in 1998-9 when the IPO markets were hot and investors were able to quickly "flip" their positions post IPO. These investors are classic "momentum investors". In contrast to "Graham & Dodd/Buffett Value" investors that base decisions upon the underlying fundamentals of a company, momentum investors make their money by identifying trends and momentum in price movement and try to turn a profit based on the fact that the stock is worth x% more in the near future.

While the mezzanine houses have retail clients, their true customer is the provider of product for them: the venture firms. If they can get access to the hottest "stories", they can raise capital at extremely high values (and hence, really high fees) with the hope that their investors will do well post IPO. The VC’s like this since it is cheap equity, Advanced & brethren like it since they get big fees and the retail clients like it since they can make a quick profit.

However, all good things come to an end. Should a "story" lose its zeal, and fundamentals become the driving force (or a market correction), then the retail clients get crushed. While this is unfortunate, I have a more moderate position on all of this. These investors should know that they are playing with fire. We all went through the Tech Ice Age just 6 years ago and we all know momentum investing when we see it. These retail investors are either a) greedy for a quick flip or b) ignorant about fundamental investment analysis. They are momentum investors and pretty much should know what they are signing up for.

Institutional VC’s won’t go near these deals, normally, with a 10 foot pole. These companies are priced at $200-$300m+ when they would struggle, often, to get above $100m in an institutional event. However, the allure of the IPO is strong and clouds judgment.

Vonage is a classic example of such a firm. We all know that telco service companies commoditize in the long run. We also know that when you have large, active incumbents on one side (AT&T, etc) and free offerings (Skype) on the other, things will likely not end well. Furthermore, as I have posted on numerous occasions, the Vonage service is horrendous. This is a situation where investors could actually sign up for the service and test it for themselves. I am guessing that few, if any, actually did.

Now, I am certain that a number of "ethical" issues will emerge over time regarding how these securities are sold. People also hate losing money and will launch a sea of lawsuits. That said, how short are people’s memories and how easily can greed overcome rational analysis (or fear)? As they say, let the buyer beware…

Another sign that the bubble is in full force and likely unpleasant things are ahead for us.

Keith Schacht and his cohorts at Freshwater Venture (no "s" on the end) have an interesting effort underway in Chicago. They are marrying known entrepreneurial efforts with a Google map mash-up, family trees and profiles.

One of the challenges with the Midwest region (and many other regions for that matter) is not that talent or resources are not there, but that no one knows where they are. In Chicago, it is particularly glaring given the depth of resources and people here. One of the Valley’s strengths is that people are perpetually networking and self-forming groups. It is either the Midwest show-me attitude or the response to cold, long winters, but entrepreneurs and techies stay in their gopher holes here. They tuck their heads, don’t self-promote much and let their results speak for them. They have not historically reached out to their peers since, well…they don’t know where they are. Only in Chicago do you have a company with a $3B market cap, has a near monopoly on its space and nearly everyone uses or looks at their product. But, alas, Navteq, hidden in the Merchandise Mart here, is virtually unknown to others even in the tech community here. There are quite a few similar stories.

I love the concept behind Freshwater and their array of secondary activities that they are working on. I look forward to seeing how their efforts continue to grow and take shape.

I am watching the "The Day After Tomorrow" with my son as I type this post. It is a Hollywood version of accelerated Global Warming. In the middle of the movie, a flash freeze sweeps across the Northern Hemisphere, immediately freezing everything in its path (minus 150 degree F) which is cold even by Chicago standards. At the same time, I was reading Daniel Primark’s piece on Sevin Rosen giving back its recent fund, stating that the venture model is broken. In it he writes (click on the link below for the full version):

"Sevin Rosen Funds has indefinitely postponed fundraising for its tenth fund, which had been scheduled to hold a first close this week. This is being treated as big news in VC circles – particularly among the battering blogbobs – because SRF is not citing the typical excuses of partnership strife or fundraising difficulties (i.e., Mobius, Worldview, etc.). Instead, it claims that the VC model is “severely damaged,” and that it will not raise additional capital until it funds a responsible solution."
— Daniel Primark Is Venture Capital Broken PE Week

The primary issue is that with the continuing weak state of the public markets, exits for venture deals are limited. When the IPO market shuts down, the M&A multiples drop since there is less competition. Venture capitalists continue to fund companies, but, like in 1998-9, the exits lag, leading to inventory backing up. Throw in a recession and you get a "flash freeze". In one of the Ice Ages, it hit so fast that mammoths still had food in their mouth and stomachs when they froze…I wonder if you’ll see VC’s with lattes frozen in their hands?

Now this is a theme I continue to bang on about. I do not disagree with the Sevin Rosen statement. With exits sparse and exit valuations down to $80-$140m, VC’s can’t return capital pumping $20-30m into companies at $50-60m post-$ valuations. This means that our wins return, not 10x, but 2-3x. This does not cover the 50% of the portfolio that tubes. However, early stage groups with large funds, some roughly 2x their previous, are now fighting to put it out. They are forced to move later stage where they can deploy larger amounts into businesses with "established" business models or pump more into early stage businesses.

We believe, as Daniel points out, that you need to reman at the seed/early stage. Get in early, keep the burn down, manage the downside and let the upside take care of itself. Keep the post-$ down and it puts less pressure on management and investors. This is the best way to manage the next Freeze.

For those of you with the political bug and a right of center leaning, Real Clear Politics is a great site. My b-school & BCG buddy, Al Warms, has really done some interesting things with the site. He lays them out in a recent post including a variety of interesting things with RSS and email powered by  FeedBurner. In particular, he has broken the content down in small elements, tagged them and made them available for distribution via RSS. Much like Om Malik’s piece on It’s a Widget World, the future of the web is about small components which users can consume or use as individual situations come up. This has always been one of the promises of Web Services in the world of Enterprise software. Do what you do best and leverage others’ creations and work to fill in the gap. Fred Wilson has written extensively on this topic (Future of Media).

Al has done this with a wide array of content on his site and users can subscribe to specifically what they are interested in. More recently, he has introduced an email service (email also powered by FeedBurner) that allows users to subscribe, not to general election news, but to specific campaigns. Very cool stuff.

Comscore released its stats on Social Networking demographics which is on the following table. What surprised me most about all of these is the high % of 35-54 year olds in each user base (33-40%). MySpace was the biggest outlier on this front with almost 41% of its visitors coming from the older crowd. Now, this is not a breakdown of members (could not find anything from a cursory web review) so, the stalkers & pedophiles could be driving this. However, I have heard of several examples of older men & women (in their aged 40’s) throwing up profiles for dating on MySpace in addition (or instead of) Match, e-Harmony, etc. Xanga is much stronger in the younger 12-18 bracket and Facebook is obviously strong in college age 18-24.

                                  Percent (%) Composition of Unique Visitors
                               Total
                              Internet  MySpace          Facebook  Friendster          Xanga
                                ——–        ———–          ————  ————–          ———
Unique Visitors
(000)                     173,407         55,778           14,782     1,043               8,066

Total Audience         100.0           100.0             100.0     100.0                100.0
  Persons: 12-17          9.6             11.9              14.0       10.6                  20.3
  Persons: 18-24        11.3             18.1              34.0       15.6                  15.5
  Persons: 25-34        14.5             16.7                8.6       28.2                  11.0
  Persons: 35-54        38.5             40.6              33.5       34.5                  35.6
  Persons: 55+          18.0             11.0                7.6         8.1                    7.3

More interesting is that MySpace is starting to skew older with a shift from 12-24 to more 25-54 year olds. Must be a lot of old rockers and stalkers…

I recently received an email asking "do we have our priorities aligned properly".  While the email was a humor email (punchline below), the first half of it was illuminating in a more serious way. In all of our individual efforts to feel important and to be recognized (socially, in business circles, publications, in boardrooms, etc), we often fail to look at things from a long-term perspective.

We can often sacrifice those things that are important to us for near-term gain. I saw a great movie recently called Fearless (Jet Li’s "final" movie). While it has all of the action and fights we guys thrive on, it had a great message about life being about self-discipline and restraint and that blindly seeking victories, glory and followers often leads down a dark path.

The email above said:
In 1923, Who Was:

1. President of the largest steel company?

2. President of the largest gas company?

3. President of the New York Stock Exchange?

4. Greatest wheat speculator?

5. President of the Bank of International Settlement?

6. Great Bear of Wall Street?

These men were considered some of the worlds most successful of their days.

Now, 80 years later, the history book asks us if we know what ultimately became of them.

The Answers:

1. The president of the largest steel company.
Charles Schwab, died a pauper.

2. The president of the largest gas company,
Edward Hopson, went insane.

3. The president of the NYSE,
Richard Whitney, was released from prison to die at home.

4. The greatest wheat speculator,
Arthur Cooger, died abroad, penniless.

5. The president
of the Bank of International Settlement, shot himself.

6. The Great Bear of Wall Street,
Cosabee Livermore, also committed suicide.

Family, friends and what you contribute for the betterment of those around you is what, in the end, legacy is made of. You can usually get just as far up the corporate or entrepreneurial ranks by helping others advance as you can by stabbing your way up. Creates a kind of Karma piggy bank. Depends on your preferred style and beliefs.

The humorous part of the email (taking a little different tack than my ramblings above) followed:
However: in that same year, 1923, the PGA Champion and the winner of the most important golf tournament, the US Open, was Gene Sarazen.
What became of him?

He played golf until he was 92,
died in 1999 at the age of 95.
He was financially secure
at the time of his death.

The Moral:
#@&* work.
Play golf.

ESPN announced that it was pulling the plug on its MVNO venture.  This is an unfortunate trend since MVNO’s are new service and application vendors best shots at getting into the market place. Since MVNO’s, by definition, are marketing oriented, they should, in theory, be more willing to integrate new apps or services. However, the carriers have realized that while they like the notion of selling profitable, wholesale minutes to MVNO’s who then do the expensive customer acquisition dance, they also found that they were increasingly competing against the carrier for its retail customers. As a result, most carriers have ramped (or shut) down their MVNO programs. Existing MVNO’s are finding customers expensive to acquire and, like ESPN, have some tough decisions ahead. This also unfortunately leaves mobile app developers with having to deal with the galatial carriers for scaling…ouch. More to come on this topic.

"The word "Tipping Point", for example, comes from the world of
epidemiology. It’s the name given to that moment in an epidemic when a
virus reaches critical mass. It’s the boiling point. It’s the moment on
the graph when the line starts to shoot straight upwards."
  — Malcolm Gladwell

Is it just me or are colds and flus starting to pack dramatically more punch these days? My wife is one of the most resilient people I know, has been down and out with a cold for 5 days. I have had two colds in the past year that were so bad that I couldn’t even get out of bed for two days and didn’t return to full strength for a couple of weeks. It could be that, at 42, I have become old and decrepit. However, it seems that the viruses are getting more powerful and, worse, the resulting bacterial infections following colds are uber-strong strains that have survived over a decade of mis- and over-use of antibiotics.

Meanwhile, most of the pharma companies have dropped their anti-infective programs since the end markets are not big enough to make it worth their while. In their place, several start-ups, like Replidyne, are working on novel approaches to deal with drug resistent bugs. Replidyne’s technology acts by directly inhibiting bacterial DNA replication. This is one of the few biotech segments where early stage companies are not competing with multiple large pharma in-house efforts.

Unfortunately, the biotech venture model is broken. The last five biotech IPO’s, which by definition are supposed to be homerun events, returned between 0.8 and 1.2 times capital invested. In venture capital, you generally want to match the amounts of capital with the level of risk. You want to deploy small amounts of capital early and increase amounts as risk factors are removed. However, in biotech, because of the high cost of drug trials, investors need to deploy $50-100m before they know if they have a credible working product. These companies can soak up $100-200m before getting through trials and nearing market launch. I’m not certain how to fix this model, but for all of good, we need to figure this out (certainly glad Bush has banned federal funding of stem cells…sorry, had to slip that in).

This combination (more potent organisms and declining pharma programs) is dangerous. While nothing catastrophic has happened to date, chaos theory shows that once a particular strain hits its tipping point, we quickly end up with an epidemic.  This won’t necessarily be the catastrophic flu that the CDC and others are fearful of. It will also include increasingly debilitating colds and infections as well as the really nasty bugs hanging out in hospitals (can you say flesh eating bacteria…). I will do everything I can to stay out of hospitals.

In the interim, gives us all a break and keep those hands washed and stay at home if sick…

After much worrisome debate, we bought a trampoline for the kids this summer. It is our small attempt of staying up with our neighbors and their seven connected trampolines. After seeing this video, I feel much better about our decision… 🙂

When I thinking of online gaming, I think of 15-24 year olds battling away until the early hours of the night, loaded with Red Bull. According to a recent Comscore Gaming report, the average gamer is 41 years old and 52% of the gamers are women. I know that some of our gaming properties have suffered in formal traffic metrics since the younger gamers blow away their cookies and tracking programs and so tend to be under represented in the counts. Would be interested in getting feedback from a couple of the Comscore readers to this blog about this. This report would indicate that there are a large number of mid-aged women gaming. Not certain if there classes of games that I am not thinking about here that would target this group.