SOPHISTICATED FINANCE

Google's View of a Startup

ReadWriteWeb has a very good post in which they "interview" Tom Duterme from the New Business Development Group at Google. The theme of the post is what does Google look for in their acquisitions. Reading between the lines, Google is looking for things that bolt on easily to their platform, make use of large, cheap data storage and utilize high speed bandwidth effectively. If you are not doing these things correctly, don't call Google.

In order to commercialize an idea, Duterme had this advice, which I quote:

* Collaboration - get the right people on your team.

* Fulfilling user needs should be the focus - 70-80% of ideas that fail do so because of lack of user focus. Google places a lot of emphasis on this, said Tom.

* Iterate often ("Big will not beat small anymore. It will be fast beating slow"; quote from Rupert Murdoch).

This advice got me thinking about how do you manage collaboration to iterate often. The CEO who has to do everything their way, the quest for "perfection" and constant minor changes are all in conflict with collaborative iteration. Why hire the best people and then micromanage or nitpick or ask for multiple do overs. The time constantly reviewing the best thinking of a smart employee is time lost that could be used more productively. If a decision will not immediately severely impair the company (bring on imminent bankruptcy) why beat it to death. The only factor necessary to consider in most decisions is whether it advances or is consistent with the strategy. Otherwise, remember this management principle which is little publicized: there is usually more than one right way to do things .

Follow this principle and your company will generate product iterations much more quickly. If you do not trust your employees enough to follow this principle, you have a recruiting problem or you (the CEO/manager) are the problem. The two problems are probably interconnected. People that do not trust typically are lousy recruiters who hire mousy people without initiative who do not challenge them.

A few signals that your corporate culture is not conducive to collaborative iteration:

1. You spend three months developing a product brochure because it's not "right"
2. Nobody can make the decision on when the next product version is ready or when it is finished
3. Nobody has the time to recruit the new sales people, programmers, ....
4. The mood in the office improves noticeably when the CEO goes out of town

Note: Duterme believes that 70-80 percent of ideas/businesses fail because there is insufficient focus on the customer. I think the percentage is correct. As I have said countless times on this blog, focus on the customer and their needs and don't waste time over thinking decisions, nitpicking the staff and re-doing things that are not key to the strategy.

Commodity Prices and Monetary Policy

I have been troubled for some time about the declining value of the dollar, high oil prices and the affordability of food in the third world. I have read quite a bit on the subject but most articles were superficial or presented analysis which was not supported by the underlying facts. A paper released this month by International Monetary Fund staffer Noureddine Krichene entitled Recent Inflationary Trends in World Commodity Markets

provides a very comprehensive explanation. Mr. (Dr.?) Krichene's expertise and specialization is in the area of the relationship between oil and gas prices and monetary policy and he works on the Africa Desk at the IMF.

Key points from the paper are:

1. The All Commodity Price Index has increased 23 percent per year in the period 2003-2007, the highest rate of inflation since World War II

2. The Consumer Price Index (CPI) in most developed countries showed comparatively small increases of 2-3 percent for the same period
3. The depreciating dollar has not lead to higher prices in the U.S. or to an improvement in the U.S. trade balance
4. The CPI is the principal indicator of monetary policy for most central banks and government monetary authorities and may have mislead them in their analysis of price stability and the correct monetary policy

In summary, we have two major economic anamolies--high commodity prices that are not flowing through to the CPI and a declining dollar which is not leading to a better U.S. trade balance. Krichene believes that excessive expansion of the U.S. money supply and resultant low real interest rates

in the period 2003-2007 have produced a "demand shock". Effectively, there is too much cheap money chasing too few goods.

To correct the situation Krichene proposes a Milton Friedman like approach whereby the U.S. government should

tighten the money supply and

raise interest rates. Such an approach would raise the comparative value of the dollar, lead to lower domestic oil prices and reduce speculative and organic demand for commodities. It would also lead to a recession, depress asset values and bring on a major wave of bankruptcies in the U.S. In other words, it's time to pay the piper. We have been living high on cheap borrowed money and at some point fundamental economic forces have to be recognized.

If I was running a company today I would be looking at reducing debt, tightening up on credit policies for customers and staying liquid. I think the next President, whoever the winner is, faces a very complicated economic situation and will probably be a one term President (we do not re-elect Presidents who have bad economic performance). And in closing, remember that we have not yet paid the bill

through higher taxes

for a very expensive war in Iraq. This little discussed fact complicates the economic situation even further. Buckle up--the ride is going to get even rockier!

Update: Steve Forbes, owner of Forbes magazine, appears to agree with the analysis and role of monetary policy, according to a post on Fractals of Change today. Maybe I should run for President :).

Note: In a post on global capital markets in January of this year I stated that because of investor liquidity I thought interest rates would stay low. I am changing my position. In the medium term (1-2 years) I think the Federal Reserve will have to raise interest rates fairly dramatically and strengthen the Dollar.

I found the

Krichene

paper on Research Recap .

The Digital Savvy--Key to Viral Marketing

The current rage in Web 2.0 is to use viral marketing to launch the site/network/widget/wiki. Few entrepreneurs ever articulate clearly how they are going to successfully initiate this miraculous series of events. Despite the popularity of the concept of viral marketing, I have seen little detailed guidance on the Web about how to achieve success with this marketing technique.

One thing I am sure of is that for most Web 2.0 businesses to achieve success with viral marketing, they must appeal to the early adopters--what some call the digital savvy. Scarborough Research has just released a report entitled Understanding the Digital Savvy Consumer: An Analysis of the Country's Most High Tech Consumers. The report states that only six percent of the population are digital savvy. A few interesting findings from the report about the digital savvy:

1. 55% are 25-44 years old, which is an older demographic than I would have expected
2. 36% earn over $100,000 per year, which suggests that competition to get their attention is fierce
3. A disproportionate percentage are Asians and U.S. born Latins, market segments that one does not see much discussed on the blogs
4. A preference for upscale, niche products that enhance their image, which suggests that exclusivity may be a good strategy to attract new users and why closed beta tests may have more benefits than originally believed
5. Costco is the most popular store amongst the digital savvy (wonder if Costco knows), which suggests that quality combined with value is a necessary product characteristic and that more sites and services could charge a fee if they provided the necessary quality of service
6. The digital savvy are big time fans of professional sports, which may explain all those Super Bowl ads.
7. Weather and news are the two most popular online information topics

The data also suggests to me that the digital savvy is really two distinct groups, but you should read the report yourself and decide. I have noticed that the readers of this blog find these excerpt posts on research studies to be one of the most popular categories that I write about. I have also noticed that few people click through to read the underlying studies. If you are an aspiring Web 2.0 entrepreneur or have an operating site, you should really read the full study.

I found the Scarborough report through a post by Dan Rua at Florida Venture Blog.

Learning

I have become convinced (for many years) that to be successful one must be a lifelong learner. It does not matter the discipline, the profession or your own starting level of education. The discipline of constantly searching to expand your knowledge in a subject or subjects just makes life richer and more rewarding. Two activities that have proven fruitful in my efforts to expand my knowledge have been teaching and blogging.

When I started teaching at Florida International University and giving workshops there I thought of it as a form of community service. I was giving back some of what I have learned about business working around the world. What I discovered was that it was an incredible source of learning for me. Being forced to clearly articulate your thoughts on a subject forces one to understand the subject better and in more depth. Fortunately I do not have the pressure to publish academic articles so I can take my learning where ever it leads me.

Brad Feld has a great new post up talking about how much he has learned from blogging. I share Brad's view that writing about a subject enhances the learning process. He also makes the very good point that you will not understand Web 2.0 until you really use the technology to generate meaningful content.

I have noticed over the years that the intensity of my efforts to learn has high and low points. The better the quality of people I am working with, the more I make the effort to learn. The less productive my efforts at work, the more I make the effort to learn. When I am working really hard on a good, productive project I tend to do less learning. This is a mistake. Whenever you fall into a period where you are not learning, there is a strong tendency for it to continue and become the norm. From teaching and blogging I have learned that there are certain activities that encourage learning. If you have not yet found an activity that leads you to learn, you should start looking for it today. For those who would respond "I learn every day", I would point out that we are talking here about profound, in depth understanding that exercises the mind. Everybody learns things by coincidental effort. I am encouraging that deliberate, purposeful effort devoted to expanding your understanding of a subject.

Memorial Day

I think there is an increasing tendency for people in the U.S. to overlook the underlying event(s) and focus on the "day off" nature of the national holidays. With fewer and fewer people serving in the military and a very unpopular war in Iraq, it is probably particularly true of Memorial Day. Take a moment on Monday to remember and give thanks for all who have given their lives for this country. While the U.S. may occasionally fight the wrong wars, nobody died for the wrong reason. They served their country when it called upon them.

eMail Our Military is a foundation that supports U.S. military personnel oversees. Babble Soft and eMail our Military have joined forces to offer free subscriptions to Babble Soft applications for active duty service members with newborns. Babble Soft provides web and mobile applications for new parents. More details are here.

I found this story about eMail Our Military on a memorial day post at A VC. Who says VCs don't have heart.

Asian VCs Now Favor Consumer and Business Services Sectors

Dow Jones VentureSource reported on 1Q 2008 venture capital investment in India and China this week. China investment is strongly up and India is down compared with the same quarter last year. More noteworthy is Dow Jones' observation that venture capitalists are scaling back investment in high tech in favor of the consumer and business services sectors. This shift makes imminent sense to some one who spent twenty years working in the consumer sector in Asia. The reasons for the shift may be:

1. High tech products sold in India and China are in large part purchased by a corrupt government/military bureaucracy, which makes sales forecasting very challenging and troubling
2. Given the inherent high level of risk in these countries, perhaps the additional technology risk queered the risk return results
3. The early high tech investment was perhaps the low hanging fruit and now the real work begins to find suitable investments
4. The LPs could not understand why more money was not going into the two largest emerging middle class markets in history

I have said several times on this blog that investing in the emerging middle class is a sound investment strategy. Nice to see that the scions of Silicon Valley may be coming around to my way of thinking

Controllers

In response to yesterday's post where I asked if anybody knew a good controller looking for a job in South Florida, a reader posted a comment to say "not being able to find an employee in South Florida is like not being able to find a prostitute in Thailand". I have not been to Thailand in a few years so we will have to trust the reader on the availability of companions in Thailand, but I can tell you that good controllers are not plentiful in South Florida. The accounting industry in South Florida is very understaffed, jobs are plentiful and people easily choose smaller firms until they find the lifestyle they want.

The minimum requirements that I set for a controller also narrows the field:

1. Public accounting experience (2-4 years), preferably with one of the ten largest accounting firms in the U.S.
2. CPA
3. At least two years experience working in a company as a controller
4. Current knowledge of GAAP, FASB, etc.
5. Strong Excel skills and model building experience
6. Self-directed
7. Speak English (the reason they need to speak English will become apparent)

This type of person would earn $80-120,000 per year in South Florida depending on experience.

Many company owners confuse controllers with bookkeepers and save money by hiring the wrong type of accounting personnel. Then they realize that they "need" a CFO to do capital raising and spend $120-150,00 to fill this position. A better alternative for an early stage company is to hire a strong controller and forgo a CFO. A good controller should be able to model the company and provide any schedule required in due diligence. The CEO should be able to write a good Executive Summary in a weekend. Between them they should be able to handle the meetings with capital sources, many of whom will not speak Spanish.

I consistently see owners of early stage companies saving money by hiring bookkeepers instead of qualified controllers. They typically end up with non-GAAP accounting, poor accounting information and no management reporting. They typically never realize that they hired the wrong accounting personnel.

Note: if you had two strong executives in the company who could both actively participate in capital raising you might get away with a Spanish speaking controller but they still have to meet all my other requirements and prove they can stay current on U.S. GAAP (which I believe is only available in English).

Miscellanea

Just a few quick thoughts on a rainy afternoon in South Florida.

1. My daughter graduated from college this weekend. Nice event and the first break of the year. Commencement theme was "giving back". Compassion is a much underrated concept.
2. President Bush told the Saudi's last week that they should lower oil prices or it would lead to increased U.S. investment in alternative energies. How we ever elected this guy to a second term is beyond me. Hopefully he plans to travel abroad for the remainder of his term and thereby not have to make any important decisions.
3. U.S. blogging appears to have hit some sort of pre-summer doldrums. Every third post involves Microsoft, Yahoo, Facebook and Google in some sort of combination. None of these combinations make much strategic sense to me and the posts are increasingly uninteresting. I wish people would just stop blogging on this subject.
4. North Korea has just made its first test call for its new cellular phone network. I wonder what the roaming rates will be for calls from North Korea back to the world. Should be a lucrative new source of income for the dictatorship. Expect an opening in tourism there soon in order to drive up roaming minutes (which are settled in USD).
5. If you are looking for a good, free anti-virus program, take a look at AVG. Anti-virus, anti-spyware, scanning of emails and downloads, etc.
6. A company that I worked with in Japan years ago just reported they are the fifth most visited website in Japan with 22 million visitors per month. I believe they are also the largest ISP. Company is called Nifty Corporation.
7. If anybody has contacts that may lead to a chef in training position in NYC, please email me.
8. If anybody knows of a good controller looking for a job in South Florida, please let me know.
9. My client 10Q is filed so I don't have to worry about that madness for another 90 days and my blogging productivity should pick up.

Oil Price Nonsense

I have heard two arguments recently with increasing frequency:

1. The U.S. should expand drilling in Alaska and the Gulf of Mexico as a means to increase the oil supply and reduce oil prices
2. The recent high oil prices are good because it provides the economic incentive to develop new types of alternative energy

An equally attractive argument is that the U.S. annex the rest of Mexico or at least the Mexican oil fields. The logic is both compelling and historically relevant

• First, we wanted all of Mexico at the end of the U.S. Mexico War in 1848 but anti-slavery forces thought that Mexico would expand the area supporting slavery and so we settled for just Texas and environs. We are no longer concerned about slavery (although the new citizenry might vote Democrat).
• Second, we would solve the contentious problem of illegal immigrants. All the Mexicans would just become citizens and we could build a really high, electrified fence along the short, new U.S. border with Guatemala.
• Third, we could take over Mexico for a lot less money than Iraq, which would lead to an acceptable ROI for the U.S.

My argument, of course, adopts the best parts of both of the other two arguments. We increase the area for drilling by "annexing" Mexico and we use economic incentives because the war with Mexico would only last two days and therefore be very cheap on a per barrel basis.

Now that we have covered all the stupid arguments related to higher oil prices let's get back to work on finding new ways to reduce oil consumption. Polluting the environment in more of the U.S. is not a viable alternative and we are only at the frontier of understanding and measuring the benefits of clean tech and alternative energy sources.

Business Plans for 13 Year Olds

With the popularity of Web 2.0 and clean tech I am seeing more and more business plans in these areas.

The Web 2.0 plans almost all involve some form of social networking site and increasingly these sites are targeting more defined and narrower customer segments. This is a good trend, but fewer and fewer plans make clear why anybody would want to come to the site and more importantly use it. Everybody believes their site will go viral or Google ads will make the site a success. If it were this easy I would have already launched my social networking site for television animal personalities (I am particularly fond of the beaver with the blackberry that drinks lattes and promotes sleep medicines). Few entrepreneurs ever explain why a particular marketing plan matches their target customer or how their site will specifically match the particular needs of a target customer. Another way of looking at the issue is-- why should somebody come to your site instead of creating a group on Facebook or a social network on Ning. If you can answer these questions maybe you have a real business idea, but if all you can say is "we are going to offer better customer service, better security and videos"-- then maybe you should go back to the drawing board.These factors are not a sustainable advantage for very long, if at all. Most of the new social networking business plans I have seen recently never describe any real differential advantage. They lack this critical component because they have not developed a very profound understanding of their target customer. They have correctly picked an underdeveloped market segment but they have not really understood the customer.

The clean tech plans typically have a completely different problem. Many of them are based on carbon credits related to the Kyoto Protocol. I have yet to read a plan that relies on carbon credits and can intelligently explain how these credits get turned into cash. Last week I met with an experienced equity salesman. After my client fumbled around for ten minutes trying to explain a simple business, this old pro asked a simple question--how would you explain this business to a 13 year old. While many clean tech entrepreneurs do not yet have 13 year old children to practice on, maybe they could use this concept anyway. (Note: 13 year old rule is a good test for any business concept.)

If people can not understand the business they will not fund you.If you can not explain the concept in terms a 13 year old can understand then you have not achieved the level of simplicity required.

Tommorow I will be judging the final round of the business plan competition at the FIU Entrepreneurship Center. When judging these competitions I almost never read the financial plans unless the business concept is sufficiently well explained to merit the extra effort. Hopefully someone's presentation will inspire me to take a look at their financials. I hope so or otherwise it is going to be a long day.

Death Spiral Financing

A couple of readers emailed to ask what a "death spiral" was, which was referenced in a recent post on Financing Fees . A death spiral is a financing where massive equity dilution is attached as a condition if a certain event does not take place. For example, you issue convertible bonds which convert into one million shares of common stock, but if the company does not go public by 2009 the conversion ratio changes to 50 million shares. In most death spirals, the existing controlling shareholders lose control if the death spiral triggers.

In my experience two types of investors offer death spiral financings--very large sophisticated investors (like the Walton family) and hedge funds. Sophisticated investors offer death spirals because they see sufficient value to be happy if they end up as the controlling shareholder. Hedge funds use them because they are another alternative to balance risk and return. The bravado and unceasing optimism of entrepreneurs make them very susceptible to death spiral financing offers. They call them death spirals for a reason. They should be the last alternative that one considers and you should be facing imminent liquidation before you accept such a financing.

Random Thoughts

My muse appears to be on vacation this week. Yes--I know this is getting to be a recurring theme, but preparing those SEC documents shuts down the desire to write about anything else. A few quick thoughts follow:

1. Microsoft pulled out of its negotiations with Yahoo because Balmer always had reservations about the deal and used the price difference as the excuse to "gracefully" exit. Nobody walks away from a deal that size over $1-2 per share. No--Steve Ballmer did not call and tell me this, but my explanation is the only logical explanation for the deal collapsing or Microsoft not going hostile. Why did Ballmer start down this road and then change his mind, consider that he and his CFO are a relatively new team that may still be finding their way.  My previous posts on this deal are here and here.
2. Warren Buffet has come out and recommended investment in Europe due to the comparative strength of the Euro versus the US Dollar in the medium term. My thoughts on the subject were here.
3. UBS has reportedly sold a $5 billion portfolio of sub-prime mortgages to a U.S. hedge fund at a discount of only 25 percent. This comparatively minor discount would support claims last week from the Bank of England that banks had over reacted in writing down the value of their sub-prime portfolios.
4. Data has been circulating on the Internet this week that shows the most popular apps on Facebook are for "fun". And all along, I thought Facebook was going to solve world hunger. Everyone building apps for Facebook may want to reconsider their business plans.

Financing Fees

Ask the VC is a blog written by some savvy guys who are all VCs, including Brad Feld from Foundry Group. Today's post deals with a real case where a founder gave up ten percent of his company to get an advisor on board with connections to VCs. I recently saw a case where a founder paid 30 percent for a 90 day bridge loan involving warrants (120% per annum). While obviously both founders were stareing a death spiral in the face, or at least I hope they were, why do so many startup entrepreneurs overpay for capital. There are several reasons:

1. There are a lot of unscrupulous advisors out there who will overcharge; that's why you do background checks and get multiple proposals
2. Entrepreneurs do not consult their advisors and attorneys; mentoring reduces the risk in startups partly because it stops you from doing stupid things and anybody can afford a five minute call to an attorney/accountant/mentor to ask what market fees are
3. Entrepreneurs do not know how to calculate the value of the equity, warrants and options they are giving up; if you do not know how to calculate the value of these instruments you should not be trading them like baseball cards
4. High stress makes for poor decision making; plan ahead

A couple of guidelines to avoid overpaying to raise capital:

1. Loan sharks charge 4-8 percent per month. If the interest rate you are paying approaches these levels (after imputing the cost of any equity you are giving up), then you can be sure you are overpaying
2. The highest fees I have ever seen to successfully raise equity was for a company with eight years of losses. The fees were 10 percent in cash and 10 percent warrant coverage (1 warrant for every 10 shares sold). I would like to point out that these fees were 100 percent contingent on the capital being raised and there was no upfront fee.
3. Upfront fees to raise capital range from 0-$25,000 and the arranger should be putting some real effort into improving the business plan and/or financial model. Fees may vary based on the city where you are located but not by too much. Anybody short of a well known investment bank does not get a six figure upfront fee. (Remember that these fees are for early stage companies and not for a $100 million private equity deal.)

The more you need the capital, the more likely you are to make a mistake. Start the capital raising process early and do not overpay.

A thank you to loyal reader, Kendall, for pointing out the Ask the VC post.