Archive for the ‘Finance’ Category

Just Add Balls

March 11, 2009

Yesterday the Xconomy blog shared an email interview they conducted with Paul Graham.  The prominent early-stage investor posits that Silicon Valley is a more nurturing environment for startups than Boston because startups put the Valley on the map.  Paul also states that he thinks entrepreneurs and investors should spend more time trying to understand why the Valley is a better place for startups.  That got me thinking about the U.S. as a whole being better than most other countries at fostering a startup culture.

In order for a startup culture to be successful there needs to be a whole ecosystem in place to support it, and the U.S. is founded on such an ecosystem.  In my opinion, the five main components of a startup-friendly environment are: 1) access to knowlege, 2) ease of incorporation, 3) funding sources, 4) viable execution, and 5) exit opportunities.

Spawning entrepreneurial activity requires access to knowledge.  Whether it be via a formal education or information resources such as publications, lectures and the internet, entrepreneurs need to know as much as possible about the space they intend to enter.  This is obvious.  And the U.S. is wrought with educational opportunities.  Of American adults over the age of 25, more than 85% have completed high-school and 27% have a college degree.  The U.S. government encourages advanced education via its numerous financial aid programs and tax deductions for interest on education loans.  Even without a formal education, though, entrepreneurs can tap into books, magazines, conferences and contacts with domain expertise.

Nobody would want to start a company if it was a nightmare process to get incorporated.  The U.S. makes the incorporation process incredibly easy.  In Delaware this can be done by filing one simple form and paying $89.  To illustrate the system in other countries, a potential entrepreneur in Mexico must file 8 forms in different government offices, and the process takes about one month.  The U.S. also offers a variety of incorporation types, such as C-corp, S-corp, LLC and Partnership.

A huge reason for the existence of a startup culture in the U.S. is access to moderately cheap capital and established bankruptcy proceedings.  Other than the turbulent economic times we are in today, the historically stable U.S. economy has limited systemic risk to both debt financing and equity financing. Our economy has also not been characterized by highly volatile inflation rates (again, present circumstances excluded). This stability, when combined with the aforementioned limited systemic risk lead to low interest rates levied on debt and moderate returns demanded from equity.  These forces have engendered entire industries of venture financing such as venture funds, seed funds and SBA loans.  Most startups in the US first get seeded by individuals with enough net worth to afford an angel investment. Due to the more even distribution of wealth in the U.S. relative to other countries, angel investors can be found in every corner of America.

Bankruptcy workouts are also more efficient in the U.S. than other countries. For example, in much of Latin America, secured creditors typically do not have priority to their collateral, and the judicial system that governs bankruptcy proceedings is weak and slow. On the contrary, the U.S. has an established Bankruptcy Code that determines the pecking order of different classes of creditors. This introduces additional confidence in financing a startup. Consideration must also be given to the standards of corporate governance that govern a Board of Directors. In the U.S. these principles have arisen from decades of legal precedence and shareholder activism. Most countries in the world do not benefit from a rich history of legal precedence and government involvement.

A critical success factor of any enterprise is a strong team to execute the company’s vision. Even in the U.S., where there is a large universe of talent, finding the right people to fill key positions is one of the biggest challenges for any entrepreneur. This challenge is magnified tremendously in foreign countries where there is only a small pool of highly-educated workers, and where many of the most qualified workers seek opportunities elsewhere, leading to a “brain drain” in local economies. Attracting strong team members in the early days of a venture is usually accomplished with stock options that are only worth something in the presence of healthy exit markets, which leads to the final point.

Just about the entire value harvested from a startup’s efforts lies in the amount of money generated in a liquidity event (or “exit”). The two main exit opportunities for a company are public offering and acquisition. Market conditions are paramount to reaping the greatest possible value from an exit, even if the company has impressive performance and growth potential. An IPO will mainly only be considered when the public markets are stable in order to minimize the risk of an offering trading at or below its issue bid, which would in turn lead to the perception of an undesirable offering and further selling. Acquisitions are also dependent on market forces such as high equity prices and cheap sources of debt financing.  Both of these exit markets have been robust for most of recent history in the U.S.  Though they are not palpable at the moment, they too shall rise again.

So there it is.  The recipe for creating a startup culture.  We should feel blessed to live in a country that fosters capitalism and an entrepreneurial spirit.  The foundation is there.  Now for the most important ingredient of all:  balls!

(Please be aware that the use of the term “balls” is a colloquial reference to taking big risks and in no way suggests a bias towards gender)

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Lottery tickets are risk-free ???

January 12, 2009

In business school we were taught a formula that can be used to determine the expected return on an asset.  It is called the Capital Asset Pricing Model (“CAPM”) and the equation is as follows:

Ra = Rf + βa(Rm – Rf)

where Ra is the expected return on the asset; Rf is the risk-free rate (i.e. 30-year government bond); Rm is the expected return of the market (i.e. S&P 500); and βa is the correlation of the asset’s return to the market’s return.

The beta (βa) of an asset is usually positive, indicating that when the overall market performs well, the asset also performs well; and when the overall market performs poorly, the asset also performs poorly.  Some industries possess negative betas, such as precious metals.  In this case, when the overall market performs well, the asset does poorly; and when the market goes down, the asset does well.

Yesterday I bought a lottery ticket just for fun.  I got to thinking that the beta of that lottery ticket is zero.  There is absolutely no correlation between my return on that lottery ticket and the return on the overall market.  According to the CAPM equation, my expected return on the lottery ticket should thus be the risk-free rate (which these days is trending close to 3%).  Obviously it is not, and thus the CAPM equation shows its limitations.

Securities that exhibit a zero or low beta are treasury bonds and staple stocks such as Clorox, Anheuser-Busch and Philip Morris.

Why Consumer Credit Will Remain Frozen

January 6, 2009

One topic that is vastly misunderstood is a consumer’s credit score.  It is not taught in school and it is seldom a point of discussion.  This is frightening as we enter what appears to be the perfect storm of a frozen consumer credit cycle.  While there are several variables that contribute to one’s score, the two main factors are punctuality and credit utilization.  In fact, these two variables account for 2/3 of one’s credit score.  Unfortunately, macro-economic factors are making it difficult for many Americans to remain whole in these areas.

For the past several years, easy credit has been a substitute for low wages.  Beyond the well-known mortgage debacle, credit card issuers doled out lean credit terms and high credit limits.  Drunk consumers continued to drink and pushed their debt balances to those limits, hoping to just be given more credit when they needed it.

Now strapped for cash due to layoffs and a shrinking economy, these consumers are not able to make their minimum payments on time.  That crushes the punctuality component of the credit score.  The other component I mentioned – credit utilization – is being sabotaged by the credit card companies who will no longer grant credit line increases.  In fact, many credit card companies are going so far as reducing credit limits and canceling cards that haven’t been used in a while.  Alas, many consumers will soon see their previously decent credit score plummet even if they refrain from making any more purchases with credit.

A credit score is a proxy for a consumer’s cost of capital.  With these scores tanking, money will be very expensive to borrow and hence the consumer credit cycle will remain frozen.  To make matters worse, newly-risk-averse lenders now have stricter credit score requirements.  A thaw will only come if either:  1) ratings agencies employ more lenient scoring metrics (e.g. forgive some late payments and allow higher credit utilization), or 2) banks re-calibrate their definition of a good credit rating.

Should things progress the way they are with plummeting credit scores and rising credit requirements, there will be a large funding gap to fill.  Therein lies the opportunity for peer-to-peer lending companies like Prosper and LendingClub.  Yes they have recently run into issues where they need to register with the SEC, but they will get past the regulatory hurdles (LendingClub already has in most states).  We may also see credit unions rise in popularity, given their lower interest rates on loans and higher rates offered for deposits compared to traditional banks.  Either way, profits will migrate away from monolithic banks and move toward the people.  The bad news is that this market will take a long time to develop, and until then the consumer credit cycle will remain frozen.