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February 27, 2009

Someone has to pay

My friend, Angelo Santinelli, posted today about the Death of Incentive.  Angelo is rightly concerned about the increasing tax burden on entrepreneurs which may dissuade some from taking the risk of starting a new business.  Angelo was nice enough to ask for my thoughts on his post before it was finished and incorporated some of my thoughts in his final draft.

However, while I sympathize with Angelo's position and agree that we need to stimulate entrepreneurship and innovation as a way to revive our economy, I also worry about how our government can get back to a balanced budget.

It's well documented that Clinton left office with a large budget surplus.  Of course, this was also during the height of a huge economic bubble.  Bush had the bad luck of an economy that was certain to come back down to earth, followed by the further negative impact of the September 11 tragedy.  I can't blame Bush for these facts which, on their own, would probaby push the government budget surplus into a deficit.

However, Bush also pushed though big tax cuts, launched a couple of expensive wars, and provided no check on increased government spending.  A new financial crisis at the end of his terms has left Obama with unprecedented deficits with the spectre of a necessary financial stimulus piling on even more debt.  I remember when a $175B deficit was a big number.  This year, our deficit is TEN TIMES that at $1.75 TRILLION. 

I hate unbalanced budgets.  It's fiscally irresponsible and puts off the inevitable reckoning.  I agree that during these times of crisis, we need to run a deficit.  And, we can afford a certain level of deficit spending.  Maybe we can even afford a $1.75T deficit for this year.  But, we need to be on the path of balancing the budget.

Obama is saying that the deficit will be cut in half in four years.  But, cut in half from this year's number is nowhere near good enough.  That's still an $875B deficit.  We have to narrow the deficit much more than that within four years.

I am sure that Angelo and I agree that Obama is proposing to spend too much.  I am very sympathetic to Obama's priorities.  I'd love to spend the money he's proposing.  But, right now, we can't afford it all.  If we can't afford it, we shouldn't spend it.  I'd like to more drastically cut the deficit over the next four years.  I'd get half of it back by lowering the spending targets.  And, I'd get the other half back by raising taxes.

This is where Angelo and I don't agree.  No one likes paying taxes.  And, I've certainly paid my share.  But, I am still very well off, luckily.  I don't think that the tax rates deterred me from being an entrepreneur or a VC.  You have to make a lot of money to pay a lot of taxes.  And, it's only those who are relatively well off that can pay more taxes so we can lower our deficit.  As long as were really careful on spending, I'll be willing to do my share to pay some more taxes.  I agree that radically higher tax rates would be a deterrent.  We can't return to the 70% marginal rates that Reagan eliminated.  But, anyone who rails against a certain tax hike should have to propose some other tax hike in their place until we get our deficit under control.

I'd like to give Obama the target of getting the deficit down to $200B within four years.  This is still a big number, except in the context of the big Bush-era deficits.  Then, we should get to a surplus two years after that.  And, we may need to run a surplus for a while to pay off all the debt we've racked up in the interim.

One thing I do think, however, is that all Americans should have a bit of pain to get our budget balanced.  I don't want to raise the taxes much on the middle class, but they should pay a bit more.  If they had a $100 surcharge on their taxes for the year, they'd be part of the solution.  We're all going to have to sacrifice something to get our fiscal house in order.  All but the poorest of us can live more economically in some way.  Let's all pitch in, pay our share, and get back to fiscal sanity.

February 23, 2009

VC can't bail us out

Starting with a Tom Friedman op-ed piece in the New York Times on Saturday, there have been a steady stream of VC bloggers who have pointed out why Tom's suggestion of the government pouring $20B into venture capital is a bad idea.  I agree.  Here are thoughts from Fred Wilson, Don Dodge, and Jeff Bussgang.

Venture capital is a business that can't scale with more dollars.  No matter how vibrant our economy is, there are only so many ideas that are worth funding each year.  Having more money available doesn't mean that more ideas are worth funding.  Quite the opposite:  having second and third-tier ideas funded as well as top-tier ideas dilutes the market opportunity for everyone.  It forces every start-up to raise more capital in order to compete.  It lowers the financial return for the entrepreneurs and for the investors.  And, as venture returns are lowered, limited partners begin to scale back their commitment to venture capital for the long-term.  So, a flood of government venture money in the short-term can lead to a scarcity of private venture money in the long-term.

Most top VCs will agree that there is too much money in the industry.  If you look at venture returns, you'd conclude that perhaps half of all venture funds should go away.  So, putting more money into venture capital clearly isn't necessary.  And, although Tom Friedman points out that some of the institutional investors who invest in venture capital are short on cash, you can be sure that there is no shortage of funds available for any top or second quartile VCs who are raising money.  The cash crunch is much more likely to begin the squeezing out of some of the poorer performing venture funds.  But, because of the huge amount of capital still out there and the long time constant on venture funds (funds are committed for 10 years, typically), any venture scale back will take a long time.

So, can the government do anything to help new technology business grow?  Well, I don't think that real early stage businesses can bail us out in the short-term.  This shouldn't be considered part of an economic stimulus, but, instead, part of a longer-term plan to build new industries.  In this light, the government has a great role as a funder of primary research.  Clean energy is one obvious place for this type of funding, but it can be done across many sectors.  It was government funding that got the Internet started (with our without Al Gore).  Government funding through organizations like the NIH still fund many of the initial developments in biotech.

Only the government can justify the initial research funding that may have no economic return.  This investment will instead help create research positions at our universities and will, ultimately, lead to companies spinning out of those schools.  I'm actively involved in the Deshpande Center at MIT, and that's a great model for assisting the most commercially viable research projects move toward becoming companies.

If you think of the funnel of potential businesses, I think that the bottom of the funnel (venture funding) works pretty well and is probably over funded.  Where we should be spending more resources is in testing out new ideas at the top of the funnel.  Although the government needs a good system of evaluating the ideas it funds (perhaps modeled on DARPA, but without the millitary ties), I wouldn't mind some overspending on basic research that may lead to the next big thing.

February 12, 2009

Ciclon Semiconductor acquired by TI

I've been traveling this week, so this post is coming one day late.  Yesterday, Ciclon Semiconductor was acquired by TI.  Ciclon manufactures MOSFETs, components used to build power supplies.  Ciclon's technology allows power supplies to be made more efficient (less energy loss, and therefore less heat given off) and in a much smaller size with fewer components (cheaper, more reliable).  The purchase price of Ciclon wasn't announced, but suffice it to say that it was a very nice multiple on the total amount of capital invested in the company.  TI is serious about selling these products as a full information page was prepared before the announcement.  I invested in Ciclon while I was at Venrock.

The Ciclon story is very instructive for today's entrepreneurs.  The CEO, Mark Granahan, identified Ciclon's core technology and orchestrated a spin-out from Agere where it was initially developed.  Mark was very scrappy and negotiated a very attractive deal with Agere.  This technology and equipment gave Ciclon a head-start on product development and allowed a Series A financing to happen in a market segment that is generally viewed as being low-margin and commoditized.

However, despite having two successful financings, Mark kept the company with a very frugal spending plan.  They leased space from Ben Franklin Technology Partners at Lehigh.  This gave them affordable office space and access to additional resources.  As they developed products and captured initial design wins, Mark built a very strong management team without over spending.  Although their customers are not yet announced, I can tell you that they have design wins in very visible products from some of the leading consumer electronics and computer vendors.  The company was able to get to revenue very quickly, including leveraging some legacy products from the Agere spin-out to lower their cash burn.

Some key takeaways from the Ciclon success story:

  • A very clear definition of the market opportunity, validated by customers at the start of the project.  It helped that they were targeting a commodity market with a disruptive technology
  • Defensible technology, with a roadmap to extend it.
  • 'Unfair advantage' derived from Agere spin-out.  Every start-up needs some key advantage in order to counteract the fact that they are a new company with relatively little money
  • Maintained frugal mindset despite initial funds raised and commercial adoption
  • Hire a world-class team.  Even a company like Ciclon faced many challenges along the way.  Their team was strong enough to overcome technical and manufacturing challenges that might have derailed weaker companies.
  • Get to revenue quickly, even if it is with an interim product.  This helped offset some of the cash burn, which benefits both the investors and the entrepreneur.

Congratulations to Mark and the team at Ciclon.  I am sure that they'll be very successful getting these products further into the market while at TI.

February 05, 2009

The Public Company Discount

Don Dodge wrote recently about public company valuations vs. private company valuations.  This is a subject that is near and dear to my heart.

You can find many examples of public companies that have solid businesses and very low valuations.  Most public tech companies that are financially stable and have enough revenue to be sure to be around for a while are valued at less than 1x revenue these days, plus cash.  Think about that in terms of a start-up:

What's a start-up worth that has $15M of revenue, runs at break-even, and has $5M in cash?  In more typical times, you might expect this company to raise money at $40-70M pre-money, depending on what the long-term upside is.  Currently, a public company with this financial profile is probably valued at less than $20M, including the cash.

This class of public companies are really forgotten.  They are too small to be tracked by most analysts.  They don't trade at very high volumes.  They sound a lot like private companies, but they have the transparency, and costs, of being public.  Investors can probably get a venture-type multiple on these types of companies, with less risk than that start-up.

I think that these types of opportunities will definitely compete with private companies for capital.  In fact, I'm betting on it...Limited Partners of venture capital and private equity funds are starting to see that this is an interesting complement to their usual investing.  They do have the asset allocation issue that Don mentioned since their alternatives are a higher percentage of their portfolio than they would like.  But, as that returns to normal, I expect some capital to flow toward more VC-like investing in the public market.

And, what happens to that start-up that has the attractive financials?  They'll get financed, but they may not get the valuation that they would like.  If they are really cash-flow break even, they'd be better off tapping some debt until better valuation times return.

Walk In the Sunshine

It's not easy for President Obama.  He's trying to be bipartisan with efforts such as appointing three Republicans to his cabinet and lobbying Republicans to support his stimulus bill.  Of course, there is no way to escape partisan politics in Washington.  I hope he's successful, and I hope it's only Rush Limbaugh who hopes he fails.  I guess he didn't buy into McCain's America First approach.

One great thing about the Obama administration so far is the improved transparency.  They have video channels on YouTube, including one for the transition.  I don't know who really wants to watch all this stuff, but I'm glad it's there.  We need much more communication and openness from Washington than we have had in the past.  That doesn't solve problems, but it does improve confidence.

And, Obama has already admitted some mistakes, as he did about his selection of Tom Daschle while he was aware of his tax issues and, more importantly, his pseudo-lobbying efforts.  Everyone makes mistakes.  They aren't a sign of weakness.  What is weak is a failure to admit your mistakes and act to fix them.

Today Obama has an op-ed piece in the Washington Post to argue for his stimulus package.  Although I am in synch with Obama's long-term goals, I have some hesitation on the current stimulus package.  I think we should be rushing out a pure stimulus that is significant, quick, and short-lived to get the economy moving.  I'd like us to think through big projects of change to make sure we get them right.  However, I have to say that Obama's openness and style give me enough confidence to give him the benefit of the doubt here.  I like his appeal to the people as they are pretty hungry to do things differently.

Supreme Court Justice Louis Brandeis said "Sunshine is the best disinfectant."  We need all the cleaning up that we can get.

February 02, 2009

Overreaching Regulation

The government has to demand accountability and frugality from those receiving our tax dollars as loans or equity, such as the automakers and financial institutions.  And, we need to make changes to Wall Street to lower the chance the excessive risk taking can bring down our economy again.  My first choice for Wall Street changes is more transparancy.  I

f the volume and nature of the credit default swaps on the balance sheets of financial institutions was more widely known, perhaps that would have increased the pressure on such institutions to lower their exposure or ensure that they have more capital to back up their risks.  However, it's clear that there was a regulatory lapse here since the credit default swaps should have been considered insurance, which would have demanded the right capital structure.

As I read on PE Hub today, a bill introduced in the Senate would require additional disclosure from private equity and venture capital funds, in addition to hedge funds.  Ropes and Gray has issued a preliminary legal opinion on the bill.

I think that this type of broad regulation goes too far.  I am all in favor of requiring disclosure of funds with excessive leverage or derivative trading.  Of course, any fund with public investments is already required by the SEC to meet various disclosure standards.    Leverage and derivative (and credit default swap) trading can cause a lot of damage if done to excess because a small amount of capital can lead to huge losses (or gains).  These types of investments shouldn't be eliminated, of course.  They have a place.  But, we should require more transparency so that the market will help limit the risks that are being taken.

However, 'long' investors who own vanilla equities (public or private) are only risking their own money.  They can make money when the equities go up.  And, they can lose the money they invested when they go down.  Without leverage, they have all of their investments backed up with capital.  So, I'd be in favor of requiring VC or PE funds to inform their investors of the amount of leverage they are employing (they probably already do that).  But, I don't see why we need more disclosure of venture firms who are investing in private companies alongside other qualified investors.

Although probably harmless, what good will it do to require VC and PE firms to list their investors?  Or, to publicly list the value of their funds?  These funds are not publicly traded, so the public doesn't really gain with this information.  I am very wary of the SEC pushing regulation into areas that don't need it.  We need regulation to protect the public good.  But, we don't need regulation for regulation's sake.


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