Stifling Entrepreneurship

Bill Warner Tuesday, December 23, 2008

Wow, if you are interested in several paragraphs of straight talk about what is happening to entrepreneurship in the United States, read Michael Malone’s December 22nd Wall Street Journal article entitled “Washington is Killing Silicon Valley.”

A New Decade of Stifling Regulation

Malone paints the ugly picture of what our government has done since the beginning of the century and succinctly adds it all up for the reader.

  • Sarbanes-Oxley has stifled the possibilities of IPOs for emerging companies with its heavy handed and expensive reporting requirements. The IPO was the major reward for investors and companies until the Congress crushed public companies with regulation, all in the name of preventing future Enrons, forcing the companies to find other forms of exits that were less lucrative. This has been a major contributor the downfall of the venture capital industry as well. Has anyone seen a company saved or a shareholder protected by Sarbanes-Oxley? Probably not, but we sure have seen IPOs go to near zero and billions of wasted dollars in conformance spent since this legislation came to be.
  • You can also thank Sarbanes-Oxley’s accounting requirements for the downfall of major financial institutions that were otherwise profitable and cash flow positive. Go find out what mark-to-market means and you will get a headache and fall ill. Our own Wachovia fell victim to this as their balance sheet was shown to be too weak to be a viable lender. Hopefully the SEC will put this practice back in the cooler.
  • FASB changed the accounting principles for how stock options are handled, by requiring them to be expensed, essentially removing stock options as a significant incentive for management and employees to participate in the upside potential of a company.

The Unknown Obama Effect

The unanswered question is what more is going to happen in the Obama administration. Throughout the primaries and during the election, Obama campaigned on raising taxes on businesses, increasing the capital gains tax, and taxing the rich. He portrayed successful companies and their management as the bad guys who need to be brought down. All easily said by someone who has never run a business and has no feel for what the contribution of entrepreneurship is to our economy.

These potential actions, along with borrowing more money from foreign countries, taken together have the potential of ending entrepreneurship and capitalism as we have known it, and as a result assure a path to socialism that will drive our economy into depression. We can all look forward to having government jobs building roads and bridges under the guise of stimulating the economy.

We Can Hope It Won’t Be So

The entrepreneur provides the very life blood of our economy. This is where new businesses and wealth creation start. On current course and speed, entrepreneurs will be silenced by having all incentives to achieve success taken away before they even start. We can only hope that Obama will take a much more moderate approach to the economy and listen to people who know what the implications of his actions will be.

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Raising Venture Capital Looks Bleak

Bill Warner Friday, December 19, 2008

The National Venture Capital Association in its annual Predictions Survey paints a pretty bleak picture of what venture capital is going to look like in 2009. Some think that it is more optimistic than it should be. After all, they cannot be so negative as to further alarm their limited partners.

But, some venture capitalists are saying that this is going to be worse than the dot.com bust of 2000 and 2001. The amount of money invested will drop considerably. The only exception might be the late stage companies that are close to a viable exit, but the valuations for these companies will be considerably compressed. It may be so bad that we will lose many venture capital firms that will either shut down operations or move to other investment instruments. We are already seeing evidence of this movement.

New Investment Significantly Curtailed

At the root of the problem is the reduction of the pipeline of money that comes to venture capital firms in the form of institutional money from pension funds and foundations. We have seen clear evidence that raising money for new funds will be very difficult and commitments for capital for current funds are already being curtailed.

If you have a company that needs its first round of venture financing, you are going to have a very hard time getting it. Only the very best deals will make it as 96% of those surveyed said that it will be much harder to get an initial investment. That’s sugar coating for “forget it.” If you are an existing company that needs a follow on round, you are going to have almost as difficult a time; so says about 93% of those surveyed.

Clean Tech and BioTech are Hot; Semiconductors and Media Are Not

Clean Tech, biotech and medical devices are the only industries that might see a significant increase in investment in 2009. Semiconductors and media, along with wireless and software, will experience substantial decreases in investment. In addition, international investments will decline as well.

Not that a large amount of venture capital money ever goes towards seed round companies, seed and early stage companies will suffer as venture capital firms use more of their money to shore up their current portfolios.

No End in Sight

We are only seeing the early signs of what is happening to the private equity world. The whole venture capital industry is in turmoil and could undergo significant changes in their investment priorities and opportunity selection. This will have significant implication on angel investors who may have to carry more of the load to bring companies through their early life.

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Internet Companies - Now Grownups

Bill Warner Thursday, December 18, 2008

In reflecting on the recent Internet Summit in Research Triangle Park there were certainly an impressive group of entrepreneurs, investors and consultants presenting on a wide variety of topics. In addition to a delightful key note presentation by Bob Young, the conference covered such topics as the current state of the internet markets, as well as the future of the SaaS, email marketing, blogging, search engine, ecommerce, mobile internet, and social networking businesses. Many related topics about venture capital, internet law, internet infrastructure and internet marketing rounded out the conference with an overall comprehensive look at the state of internet-based businesses.

However, it struck me how different this group of people is from the comparable group of people who were presenting as little as eight years ago. During the dot.com era of the late 90’s and early 2000’s, there certainly was as much enthusiasm as we saw at this Internet Summit, but the business maturity of the presenters at that time was far less than today.

In the dot.com era, we would have heard about how “cool” the internet is and what the possibilities are for reaching consumers and collaboration, but not much on why any of it made business sense. Yet, these companies got millions of dollars to try out their ideas; signed on the backs of napkins over a beer at the bar.

At this Internet Summit, the discussions and presentations were distinctly different from the dot.com era:

  • We heard about successful business models instead of business dreams.
  • They presented where internet commerce is today in dollars and cents instead of the assertions that it will be billions someday.
  • We got information on what works and what doesn’t work in internet marketing and blogging instead of claims that everything works.
  • Entrepreneurs talked about how revenue traction is effectively achieved instead of boasting that the world would beat a path to their doors.
  • Venture capitalists were discussing quantifiable markets and revenue models that work and had solid opinions on what makes business sense instead of clamoring to write checks.
  • The black cloak was taken off of email marketing with a very real perspective as to why it makes sense today, instead of glossing over its simplicity.
  • We heard about the details of what makes the SaaS model effective and the solutions to the real issues of successfully deploying the infrastructure and achieving cost effective marketing and sales programs instead of words about moving to the ASP model because it is cheaper.
  • They presented solid business rationale for mobile applications and the outlook for new mobile technologies instead of explaining how cool ringtones are.
  • The realities of social networking were presented including a balanced view of this delicate business model instead of projections about the wonderful world of collaboration.
  • We got the down-to-earth realities about the future of search engine businesses were presented in a very candid and realistic way instead of the techno-geek talk of the dot.com era.

There was a distinct absence of the unrealistic zealots of the dot.com era. Where did they go? Heck, many of the people we saw at the Internet Summit were some of the very same people who made the outrageous claims during the dot.com era. They look older now. They sound like business people with a purpose. They make sense.

Then it dawned on me. Many of the entrepreneurs of the dot.com era have grown up and are now adults in the business world. They have learned a great deal from their experiences, regardless of success or failure. They are seasoned and thoughtful business people who absolutely know the ins and outs of their businesses. They are well connected to their industries and know exactly how their business models work, know what’s wrong with them and have innovative ideas on how to fix them.

Out of the ashes of the dot.com era has come a powerful bread of internet business professionals that know how to build successful internet-based businesses. In fact, they are teaching others as they lead their companies and mentor other entrepreneurs in the community. We are not in Kansas anymore. You can have much greater confidence that this industry is now being led by some of the brightest, energetic and insightful business professionals in America.

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Raising Angels - Finding Investors in a Recession

Bill Warner Thursday, December 11, 2008

The Angel Capital Association (ACA) has reported a 10 percent decrease in angel investments in 2008 versus 2007. In their recent report, we are seeing the direct evidence and implications of the slowing of angel investment that started in the early fall of 2008, along with a forecast that it will continue through 2009. Nevertheless, some angel organizations have continued to invest strongly through this year and will continue to look at new deals next year. Read the ACA Angel Group Confidence Report

Angel Investors Feel the Recession

The entire private equity food chain is feeling the effects of the economic downturn and the results are the same for angels as they are for venture capital and investment banking. In this case, the source of funds for angels has been squeezed considerably with the market decline, causing them to pull back on making new investments. This is the same effect we see in the private equity firms that get their funds from private institutions whose investment portfolios have been similarly squeezed. Even Silcon Valley is feeling the pinch. As far back as April Tom Foremski wrote about his concern about the loss of angel investors in this recession because they are the front end of lots of venture capital deals. Now it’s coming true.

New Angel Investing Opportunities Exist – Even in a Recession

The most astute angels see opportunity though and FundingUniverse can give you some insight as to how they are thinking. There will be some very good deals to be seen in the coming months as valuations are tamped down and investor preferences are increased. The issue is whether or not they have enough money to make these new deals. The issue they face is that they need to keep more money in reserve to shore up their current portfolio of companies, because their companies are going to have a very hard time raising any new capital in the coming year. Any company that can’t see its way through the end of 2009 with its current capital infusion could be in serious trouble. This is why angels are asking their portfolio companies to tighten their belts by driving sales while cutting cost and expense.

More Syndication Among Angel Investors May Help

The ACA report points out that syndication among angel organizations could become much more important than ever before. The demand for angel financing is going to continue to be strong, but less money is available to invest. By having multiple angel organizations participate in a single investment opportunity, more deals could be made while increasing portfolio diversity and reducing risk.

Early Symptoms of Recession for Private Equity with No End in Sight

We are only seeing the early signs of what is happening to the private equity world. Venture firms are acting like first line managers and focusing on the uses of cash and managing burn rates. The whole venture capital industry is in turmoil and could undergo significant changes in their investment priorities and opportunity selection. This will have significant implication on angel investors who may have to carry more of the load to bring companies through their early life. Stay tuned.

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Social Networks - What’s New Here

Bill Warner Monday, December 08, 2008

The current social network phenomenon may finally be getting enough traction to become a viable business model. Since the mid-90’s there have been many attempts to bring this concept to reality on the Internet, but they never really stuck to the extent that viable businesses could be built on the concept. We used to call it collaboration and extolled the capabilities of the internet to reach people of common interests. However, the early attempts were clunky for the users, hard to administer, offering marginal value to the users, and limited in reach.

What changed? Over the last ten years many innovations have made this concept much more viable as a business model:

  • Clearer recognition of the unique needs of each social network
  • Search engine effectiveness and optimization
  • Pervasiveness of internet access
  • Integration of collaboration tools
  • Technology innovation that makes the internet more accessible

This evolution of technology and market know-how may have now reached a tipping point where we are going to see the survival of the fittest of profitable social network businesses.

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Private Equity in a Tsunami

Bill Warner Monday, December 08, 2008

To use an analogy, we have a fault line in the earth’s surface in the credit markets. The pressure became so great between the tectonic plates of home mortgages and bank solvency that the fault line shifted causing a massive earth quake that was felt around the world. The resulting tsunami devastated the shores of the public markets which in turn decreased the value of private institutions and foundations. The tsunami is still reverberating around the world and has now reached private equity firms and individual investors.

Look to Your Government for the Cause of the Pressure

All of this is a result of congress and the administration applying the pressure on banks to make bad mortgage loans to people who couldn’t afford them. Add to that the incentives given to banks to protect them from these bad loans through Fanny Mae and Freddie Mac. This pressure had been applied for over 30 years, since the Carter administration, until finally the fault line gave way causing a massive economic disaster. The shame of it all is that they knew it was coming and did nothing about it; thanks especially to Barney Frank and Chris Dodd. Now our government, who has mismanaged Social Security and Medicare, is going to help to manage financial institutions that they drove to insolvency and potentially the auto industry which they have regulated and maneuvered into uncompetitive and bloated monoliths. God help us. We really need more pressure across more fault lines in our economy.

Private Equity Feels the Pain of the Tsunami

The most recent news in the New Your Times is a case in point. Leon Black of Apollo Group says that “Traditional private equity is dead and has been for a year, and it will probably remain so for a couple of years.” Private equity has enjoyed several very good years as markets expanded. Now with markets declining, many of them are in dire trouble, especially if they have high debt. Some private equity firms are aggressively renegotiating their debt agreements, begging for more time to turn themselves around. The institutions that they rely upon for capital were crushed in the tsunami and are pulling capital out of the private equity markets. This is bad news for companies looking for venture capital financing, because the source of their funds is drying up. Apollo is not alone. Other major players are scrambling including Blackstone Group, Kohlberg Kravis Roberts, and the Carlyle Group.

Private Equity Firms May Rebuild as Something Else

Mr. Black remains optimistic and says he is poised for the further turbulence from the tsunami. He has recently gotten additional funds which he will use to buy cheap debt. He says that the big money over the next few years will be made in vast restructurings; the financial, operational and structural changes that companies will need to make if they hope to survive the economic malaise. He will probably have to start with some of his own companies.

This case in point is simply evidence that private equity firms are not going to stand still and allow themselves to fail. They will move to where the money and opportunity is. Cleaning up after the tsunami might be a very good place to start and hopefully the government will stay out of the way this time.

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Venture Capital - Who Needs It

Bill Warner Sunday, December 07, 2008

According to observers at TechCrunch there are more signs of weakness in the venture capital world. Private equity in general is very much weaker due to the economic downturn as institutions pull back on their capital commitments and private equity firms reduce their new investments trying to reserve cash to protect their current portfolios. Some institutions are even selling off some of their investments at large discounts. Now we are starting to see increasing layoffs in venture firms as they reduce unneeded staff.

Surviving Without Venture Capital

Another interesting perspective is emerging as seen in Paul Graham’s recent blog. It is evident that starting many online businesses doesn’t take as much capital to get started as it takes a pure software company. Many of the services that an online business needs are already available, like marketing, sales, distribution, payments, etc. Obviously it takes capital to develop the unique aspects of any new service offering, but that is usually the role of angels and friends and family investors, long before any venture firm wants to get involved. This observation coupled with the more astute business experience of today’s entrepreneurs leads many of them to conclude that they do not need venture capital money. Their intent is to get to positive cash flow through grants, loans and angel money.

The Role of Venture Capital is in Question

This perspective applies to the limited number of businesses that don’t require much unique infrastructure to become operational. Because it is now so hard to raise venture capital, many new companies are going to design their business models in a way that will exclude the need for any funding after the seed round. I think we are going to see more news about how the role of venture capital is going to change in this recession.

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Raising Venture Capital in the Economic Downturn - A Different Beast

Bill Warner Thursday, December 04, 2008

You may run into some articles and reports on private equity that talk about great performance in 2008. The danger is that these reports are usually talking about the first half of 2008, long before the roof feel this summer. Of note is the Venture Capital Deal Terms Report that highlighted the fact that “despite the credit crunch, the fund-raising climate for start-ups remained favorable through the first half of the year.” Well, that might have been somewhat true, but it isn’t any more. Ron Conway seems to agree.

Credit Flow Slows

The “credit crunch” started a house of cards to fall. The credit flow slowed as a result of the greatly weakened balance sheets of financial institutions substantially caused by the rapidly declining value of their mortgage backed securities. This materially hurt businesses of all kinds who needed credit. Then the bailout was proposed and passed, giving the American people the chance to pay for this problem. We then saw the markets fall into the ditch, to the tune of 30%-40% of market value lost.

Private Equity Feels the Pain

That’s all very unfortunate, but how does this affect a company who needs to raise private equity. The connection is that private equity firms (i.e. VC’s and Investment Bankers) get their money from large institutions like pension funds and private foundations. These institutions become the limited partners in private equity funds and have strict agreements with the private equity firms that spell out the kind of financial performance that is required. Unfortunately, these institutions are also heavily invested in the public markets, so their portfolios of investments just got hit with an axe. This is literally causing them to reprioritize their investments in private equity funds, to the extent that they are backing away from previously made investment commitments and actually divesting themselves of these investments. That means that private equity firms will have less money to invest in new deals, and they are putting pressure on their portfolio companies to conserve cash. Your chances of getting another round of VC funding are going to be very low.

Angel Investors More Flexible

The angel investment world is similar in many ways, but not as dire. Angels are investing their own money, so they don’t have the pressure from limited partners that VC’s have. However, their personal portfolios also got hit with that same axe, so they are hurting in the same way that the institutions are. As a result, the same reprioritization is occurring. Many angel organizations are asking their portfolio companies to conserve cash but telling them that they are with them if they need more money. This means that angels are holding money in reserve to protect their current investments, which also means they will have less for new investments. Angels are entirely more flexible and willing to work through this because they can make a unilateral decision about their own money and they invest in start-ups for many other reasons than to just make money. Nevertheless, it is going to be quite hard to raise angel money in this economy, but if you have a business with a lot of potential, you have a chance.

So, be careful about anything you read about the state of private equity. If it has not factored in what is now happening, you are in danger of having a very incorrect picture of your chances of getting angel or venture capital financing.

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Investing in Alternative Ethanol Fuels

Bill Warner Wednesday, December 03, 2008

What is happening to the ethanol business in the US? What did we get for the increase in grocery prices? Not much except for a higher cost of living and no corn. Ask anyone in the restaurant business what they think. Well, private equity investors aren’t too happy either. VeraSun is bankrupt, Aventine Renewables is trading at less than $2 per share and Hawkeye Holdings wasn’t even able to price its IPO. There continue to be reports that a gallon of ethanol takes more power to produce than it actually creates. Now with lower oil prices, the price of gasoline is hard to beat. Could it be that ethanol is not the right way to go?

Private Equity Bailing Out of Ethanol

Ugh, this is not what the “clean fuel” guys want to hear. Basic economics doesn’t seem to matter to them as they pursue their misguided view of the right alternative to reducing our dependence on foreign oil. This whole movement has been characterized by “firing now” and “aiming later.” Drilling for oil now and exploiting our natural gas potential is probably the best route to a practical approach to reducing our dependence while investing in sensible energy alternatives and maintaining some semblance of economic stability.

The private equity folks seem to see it that way too. For example, the Paladin Capital Group is leading the formation of a new ethanol production and infrastructure platform, called Vital Renewable Energy (VREC). They are assembling hundreds of millions with other participants being Leaf Clean Energy Company, Petercam Asset Management and PCG Clean Energy & Technology Fund.

Ethanol Investment Moves South

The interesting thing about this is that they are avoiding two major problems with this industry: the United States market and using corn as the basis for production. Instead, the company will focus exclusively on the Brazilian market, which is almost entirely based on sugarcane. Other private equity firms are poised to follow this same model.

The Brazilian ethanol market is booming, due to both the cost-effectiveness of sugarcane and a national adoption of ethanol as the power source of choice. No such commitment has ever been made in the US. Ninety percent of new cars sold in Brazil are flex-fuel, and new plants keep popping up to satisfy demand. VREC will focus on building new production plants, which will include co-generation facilities that can sell gas byproduct into the Brazilian power grid as well.

Lessons Learned from Corn-based Alternative Fuels

The U.S. ethanol experience, while characteristically distinct from Brazil, has scared off a bunch of would-be investors. Private equity investors ran to this corn-based alternative like thirsty cattle in the desert. It appears that not a lot of due diligence was done to assure themselves that they had the right business model and national infrastructure to make it work. Now with gas prices falling below $2.00 per gallon, the economics are even less attractive.

This is not to say that there is not a workable ethanol business model. It does say that corn is probably not the right foundation and that the US may not be the best place to start. Think of the opportunity for other South American countries as well as Southern African countries, where sugarcane can grow the best. Investments in production facilities could mean a brand new economy for these countries, and US investors can participate in making it happen. Meanwhile, let’s drill for some oil and natural gas, and dig for some more coal, in which we have abundant reserves.

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