Archive for the ‘Venture Capital’ 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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Everyone back off Tom Friedman

February 24, 2009

This weekend Tom Friedman wrote an op-ed piece in the NY Times postulating that the $20 billion of government money that GM and Chrysler are asking for would be better utilized by the top 20 venture capital firms in the U.S. because they fund companies that drive innovation and create jobs.  Tom gave a strong endorsement to the venture capital model.  Yet VCs all across the country took offense and backlashed at the suggestion.  Below I will list some of the reasons the VC community gave for their pushback, along with my humble two cents on each.

1)  The venture capital industry does not need a bailout, especially the top 20 firms.

  • True.  But Friedman’s post is not about bailing out VCs.  It’s about the wisest allocation of $20 billion.  The only statement he makes that could potentially be misinterpreted as a suggestion the VC industry needs a bailout is regarding LPs having trouble keeping their funding commitments.  This is a well-known fact and does not suggest the VC industry needs a bailout.

2)  The top 20 firms don’t need help raising money.

  • Usually true.  But that doesn’t matter.  I don’t need help opening a door but I do appreciate when someone holds a door open for me.

3)  There is already a glut of capital in the VC system.

  • Perhaps true over the entire industry, but not necessarily at the top.  Several prominent firms are raising annex funds or are concerned about their levels of dry powder.  Kleiner, Bain Capital, Onset and Battery are just a few of the firms that fit this description (though it is a seed fund, First Round is also raising an annex fund).  Admittedly, the $20 billion Friedman writes about is a large amount for the VC world, given the average amount raised annually by the industry over the past four years is $30 billion.  However, Friedman used this number because that is the latest amount under consideration for GM and Chrysler.

4)  Government money would lead to reckless investing.

  • This is ridiculous.  The best VC firms enjoy that reputation because they invest judiciously in companies that exhibit strong upside potential.  These VC firms then nurture these companies with industry connections and a Board presence.  I cannot imagine Sequoia making imprudent investments just because it received a large injection of investable capital.  These firms aren’t the nouveau riche types.  They’re not like hip-hop stars who blow all their money on cars and yachts the first chance they get.

5)  Government money would have lots of strings attached.

  • Possibly.  Given the restrictions placed on banks receiving TARP money, this is a safe assumption.  Yet it is not certain.  Besides, LPs invest in a VC fund under the premise that the partners will invest that money within parameters defined in the fund’s charter.  These parameters can be broad or specific, and there are always exceptions, but general partners are accustomed to considering the charter before making an investment.  Furthermore, from an administrative perspective, it is much easier to have a small number of LPs in a fund.  Having the government as a fund’s sole LP would be far easier to manage than a roster of hundreds of LPs ranging from institutions to wealthy individuals.

So everyone should back off Tom Friedman a bit.  He made a statement that speaks highly of the venture capital model and the role venture capitalists play in driving the country forward.  As a taxpayer I would be delighted to be an LP in the country’s best venture capital funds.