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February 28, 2010

Get the torches and pitchforks!

OK, this issue gets me mad enough to riot in the street.  I read Runaway health costs are rocking municipal budgets in today's Boston Globe.  If you live in Massachusetts, you have to read this article.  It describes how our municipal employees are getting extraordinary health care benefits.  Many employees get lifetime health care for themselves and their families after working as few as six years.  Some towns don't force their retirees onto Medicare at age 65, carrying their health care costs on town books instead.

The combination of longer lifespans, skyrocketing health care costs, and these generous benefits are driving up the share of municipal budgets that are taken up with health care.  The average town surveyed by the Globe has had their health care costs grow from 8% of the budget to 14% in the past decade.

Now, anyone running a business or buying their own health insurance knows that costs have gone up.  You can't blame the cities and towns of Massachusetts for the overall rising costs of health care.  But, municipalities in Massachusetts are constrained in increasing property taxes under Proposition 2 1/2.  Cities and towns have had to learn how to live with constrained budgets which is, overall, a good thing.  However, one thing that hasn't been wrung from budgets are overaly generous health care benefits.  These health benefits are forcing cities and towns to cut essential services like police, fire, and education.

I can see the point of having generous health care benefits for municipal employees during employment.  These jobs are generally not high-paying positions.  Generous health care benefits can be a nice perk.  I can even understand why someone should have some continuation of benefits as part of a severance package if they leave under certain circumstances.  But, these should be limited and in line with the time of service.  A very long serving employee who is let go through no fault of their own deserves some severance.  But, not for life!

And, what's the justification for continuing to cover retirees on the municipalities books beyond age 65?  That's what Medicare is for, and we all pay for it already.  Instead, these retirees are getting gold-plated benefits at the expense of hiring other employees like teachers.

Even worse, some towns have huge unfunded liabilities for health care.  The total for Boston is $5.7B!  How do they fix problems of this size without raising taxes (very limited opportunity for this under Proposition 2 1/2) or continuing to cut essential services like police, fire, education, libraries, trash collection, etc.

The worst example: The widow of a Lynn police officer who retired on disability in his 30s in 1953 is still receiving city-subsidized insurance - 57 years later.  This police officer couldn't have had more than about 15 years of service.  But, his widow gets health insurance for 57 years!  Wow!

What to do about it:

  • Pass a new state law that limits retirement benefits for municipal workers to something proportional to time served.
  • Other than severance benefits proportional to time served, no continuing health care benefits should be allowed for municipal employees who leave their job before retirement age.
  • Require municipal retirees to go on Medicare at age 65.
  • Void all elements of current collective bargaining agreements that contravene these measures.

This might be seen as draconian by some, but the State has an interest in regulating this.  First of all, the State provides local aid to cities and towns.  That money will get consumed by overly generous health care benefits unless regulations like these are in place.  Second, the State will end up bailing out cities or towns that go broke under the yoke of these benefits.  Therefore, they have an interest in cutting this waste.  And, third, it may take forever for each city and town to wrestle with these issues on their own.

I'm going to send a note to the Governor's office and to my state senator and representative about this.  Find out who yours are here.  I'm also going to find out how much my town, Bedford, is paying for these types of benefits and whether we require retirees to go on Medicare at 65.  I urge you all to do the same.

Thank goodness the Boston Globe is still in business.  Who else is going to do this type of local investigative reporting?

This one is worth rioting in the streets over!

February 22, 2010

Authority is the key to freedom(?)

I really enjoyed this TED Talk from Phillip K. Howard about overhauling the US legal system.  A key point was the authority doesn't abridge freedom but actually enables it.  It sounds counterintuitive, but in Howard's context, I agree.  I certainly agree that our legal system has smothered itself with laws that are now almost impossible to internalize.  Let me know in the comments what you think.

 

High Risk ≠ Innovation

My friend, Chris, sent me a link to Why Venture Capitalists Avoid Innovation: They Like Making Money, written by Andy Singleton.  It was interesting reading, but I don't agree with many of the conclusions. 

One of the author's complaints is that VCs "claim to be in the business of innovation, but they also talk constantly, often in the same paragraph, about how much they want to avoid innovation."  However, Singleton is confusing 'innovation' with 'risk.'  There are lots of types of risk with any new venture:  technology risk, team risk, market risk, competitive risk, development risk, sales and marketing execution risk, financing risk, etc.  A brief word on each:

  • Technology risk -- The risk that some fundamental new innovation just won't work.  This tends to come up more often with 'hard' technologies like semiconductors, energy, drug development.  This is different from development risk.
  • Team risk -- The risk that you either can't build a team with suitable skills or that the team you build won't work effectively together.
  • Market risk -- The risk that the market for your product won't appear.  Perhaps you are counting on some market shift in the future.  If it happens, you'll be the big winner because you saw it first.  If it doesn't, you may be dead.
  • Competitive risk -- The risk that existing competitors in your market can fill the need that you are trying to fill more quickly than you can.
  • Development risk -- The risk that your development team will be ineffective and fail to build a product that works well and/or is done on schedule.
  • Sales and Marketing Execution risk --A set of risks ranging from getting the product requirements correct so that engineering builds the right thing to the ability to generate sufficient awareness and demand for the product to the ability to actually get customers to part with their cash in exchange for the product.
  • Financing risk -- The risk that you can convince investors, now and/or in the future, to invest in the company in light of all these risks.

There are probably other risks (add in the comments), but these are the main ones I think about.  One problem in Singleton's post is that he equates innovation to risk, and most likely technology risk.  I look at it differently.  I think that an investor looks at any early-stage company and weighs the risks versus the potential upside.  If they can mitigate the risks and the upside is big enough, they invest.  If the risks look too big and the upside doesn't justify them, they pass.

How would you mitigate some of these categories of risk?

  • Technology risk -- Is there a proof of concept or prototype that demonstrates the technological achievement?  Has the team demonstrated the ability to project the technology advance in the past?  Is there independent diligence that validates the planned technological advance?
  • Team risk -- Have you worked with the team before?  Have some of them worked together before?  Does that validated track record give you the confidence that they can execute the plan?
  • Market risk -- Are there early market trends that will tell you if the market is shifting in the direction you are hoping for?  Is there a fallback or interim plan that will keep the company going if the market shift happens later than you predict?
  • Competitive risk -- Can you gather some competitive intelligence that will give you a hint of what the competitors' plans are?
  • Development risk -- Similar to team risk: Does the technical team have a validated track record of developing similar projects with high quality and on time?
  • Sales and Marketing Execution risk -- Another team risk:  Does the Sales and Marketing team have a validated track record in specifying the product correctly, building awareness and demand, and closing profitable business?
  • Financing risk -- Does the plan give the company sufficient cushion to ensure that they can get far enough to attract additional investment?  Will an objective new investor be attracted to this opportunity?  Is there room for a reasonable valuation step up in valuation while still leaving room for a new investor to make sufficient money?

From my experience, the most common reason why a venture-backed IT company fails isn't technology risk but sales and marketing execution risk.  Products are poorly specified, requirements aren't honed sufficently, products are positioned poorly and undifferentiated, sales teams are ineffective, etc.  It's hard getting all this right.  If you don't, even the best product won't sell.  In fact, great sales and marketing execution can make a success out of a mediocre product.

The second most common reason is market risk.  Oftentimes start-ups are projecting that a new market segment will open up that they can capture.  If it doesn't happen, or doesn't happen before the start-up runs out of money, you are in trouble.  Hopefully, there is some sort of fallback plan.  If not, you are probably dead in the water.

Most VCs take on some level of technology and development risk as history shows that many times these can be overcome.  In fact, the first thing I read after reading Singleton's post was about Bloom Energy.  If that's not VCs backing innovation, to the tune of $400M, I don't know what is.  Of course, I am sure that these VCs see gigantic potential upside and had plans on how to mitigate the risks before they invested.  And, there are many others in clean tech, drug discovery, etc.

Some of Singleton's comments on the state of the VC business are accurate, but don't impact the calculus around these risks.  Some firms are more risk averse, but they still evaluate deals along all these axes.  An innovator has creative ways to mitigate these risks.  That's the type of innovation that VCs are looking for.  There are very few deals with no risks and big upside.  Instead, most VCs are looking at how some or most of these risks can be overcome.  It may be a high bar and may not always sound reasonable.  Perhaps they are looking for business innovation rather than just technological innovation.

Before you present your company to an investor, make sure you have thought through all these risks and what you would do to mitigate them.

February 15, 2010

Next Up at the ART - Paradise Lost

I've blogged a lot this year on the season at the ART.  It's been fantastic, with several of the productions selling out night after night.  Right now, the only thing still running is The Donkey Show, which has been extended into the summer.  Despite having some regular attendees who have seen it as many as 20 times or more (!), the Donkey Show is still exciting for first time visitors.  If you haven't seen it yet, you're missing a fun and unique night out.

Later this month, the next production starts at the ART, Clifford Odets's Paradise Lost.  This looks to be a timely production as it is focuses on the Great Depression.  It should have some applicability to today, of course.  I want to pass on a special offer for those of you willing to try the production of Paradise Lost in its early days.  The offer is to get 2 tickets for the price of one.  Buy your ticktes online using code LOST241B.  You must buy tickets by 2/21/10 and this is only good for shows between 2/27-3/5/10.

Here's some background on Paradise Lost.  Also, check out some of the ART teaser videos, including this one.  Hope to see you at the theater!

Moving Forward Full Speed

As mentioned in my previous post in this series, now that I have told the story of the wind down of our investment fund, I'm now moving forward by going back to my earlier background in an operating role.  My investment career spanned almost 11 years, and I learned an awful lot during that time.  But, I think it's time to go back to an operating role.  Here's why.

First of all, the investment world, particularly things related to venture capital, is a shrinking one.  It's well documented that the number of venture funds in the US is dropping, and the funds that are surviving are raising significantly less money than before.  So, like a game of musical chairs, there are just fewer possible jobs in venture capital.  Since I don't have a firm hold on an existing VC job, it's not likely that one will be available for me somewhere else.

Second, I've joined two existing venture firms in the past.  No matter how good the firm is, it's always different on the inside.  Partnership dynamics are much different than corporate politics.  In a company, you clearly know who your boss is.  And, it's easier to move around the company, or even leave if you choose to.  In a partnership, you have a dynamic of shared management and, often, unclear hierarchy.  That can be part of the attraction as you can join and be a partner.  But, some partners are more equal than others.  And, large partnerships are more difficult to manage than large companies.  More importantly, it's not clear that the best investors, who tend to rise in venture capital firms, make the best managers.

For all these reasons, I'm not interested in joining an existing investment firm.  And, I just spent 2+ years trying to start my own.  So, even if I wanted to remain an investor, it may not be possible.

More importantly, I'm not interested.  It is attractive to be an investor for many reasons: 1) potentially high current compensation, 2) spreading your risk across multiple opportunities, 3) challenging and broad work, etc.  But, it's been very tough to be a successful investor in the past decade.  Even many of the best venture capital firms have had few distributions to their partners due to their few successes being diluted by the larger number of meager returns.  There hasn't been as much money made in this business over the past decade as your friendly VC may lead you to believe.  If you've been an investor in a VC fund, you've probably seen this first hand.

I'm much more excited about taking on an operating role and getting something done.  I'm being highly selective about opportunities I consider, but I have seen quite a few very interesting projects in a short amount of time.  I think that right now the best entrepreneurial opportunities are better bets than the best VC jobs.  And, three VC friends of mine agree, telling me that it's better to be an entrepreneur right now than to be a VC.  We'll see, but it sure is energizing.

I've committed to one opportunity with a business partner.  The details are still being kept under wraps, but we've received fantastic customer feedback and some strong investor interest.  When we're ready, I'll talk about that opportunity here.  Until then, I'm sure I'll find some inspiration from my travel through the fund raising process as we get the company off the ground.

February 03, 2010

Undaunted by the meltdown

Here's the next chapter in my 'What happened to Sempre' series.  If you haven't been reading along, the previous posts described why we decided to pull the plug, a look back at how we got started, building the team, and a discussion of our initial strategy of VC-style investing in public microcap stocks.

Once the market melted down in September 2008, we had to re-trench.  Our investor traction was gone, and we felt that we had to re-examine our proposed strategy in light of changing times.  As you may recall, there were a lot of people thinking that our economic world was coming to an end in the fourth quarter of 2008.  We decided to not do much fund raising during this time due to the high level of uncertainty.  Instead, we thought about alternative strategies.

First of all, our strategy of investing in microcap stocks had to go.  Although still economically viable (and remaining so today), there was no appetite for this type of strategy on the part of investors.  They were worried about continued downside risk and didn't see a lot of upside in a straight equity-only strategy.  That was coupled with increased risk aversion on the part of investors.  If we continued to pursue that strategy, we were dead in the water right then.

As some of our potential investors pointed out, one of our partners, Tim O'Loughlin, had an extensive background with venture debt.  This type of financing was very much lacking in the marketplace, particularly for later stage companies that may have trouble borrowing from banks.  We spent some time investigating this strategy and decided to pursue it.  Here's why:

First of all, most venture debt funds focus on lending to very early stage companies that have strong VC backing.  As a company, I never understood this.  If I am so early that I have no revenues, why would I borrow money to finance my product development?  Shouldn't my equity investors put more money into the company rather than use their funds to pay interest on a loan?  Here's the rationale that a venture debt firm will give you:  We will give you additional money so that you can get more work done on your Series A funding, hopefully earning you a higher valuation on Series B.  In exchange for that, we'll earn some interest and take a small warrant (option) position in the company in preferred stock.  If everything works out fine, that's all true.  The initial investors and management team will end up somewhat better off in this scenario.

But, not enough people think about what happens if things don't work as planned.  And, how often do things work as planned at a start-up?  If you fall behind plan, your lenders will get nervous and perhaps consider taking your last amount of cash in order to satisfy their loan.  At the least, they'll take up a lot of management and Board bandwidth getting reassured that additional capital will be coming into the company to service the loan.  Hopefully, the investors will realize that the lenders are expecting to get repaid and won't try to force them to convert their loan to equity.  This can lead to a game of 'chicken' being played with the company.  No one really wins these games. 

Why do venture debt players do this?  Because they are essentially loaning money to the venture capital firms and not the individual companies.  This 'off balance sheet' leverage can be helpful to a VC firm, and the risks are pretty low as long as the lender and VC investor have a good working relationship.  Despite this, I don't think that companies should borrow very much money until they have revenues to pay the loans back.  The issues and risks of the downside scenario don't balance out the upside opportunity.

That's where Sempre's Capital Access strategy fit in.  We were going to loan money to companies that had revenues and were at or near cash flow break even.  Most venture debt firms don't loan to these companies because they perceive the warrant upside to be smaller than with the early stage companies.  However, because capital is scarce, the interest rates you can charge are very attractive.  And, the risk of loss is likely to be lower.  Even if the company fails, they have a real, revenue-producing business that is more likely to have salvage value than an early-stage pre-revenue start-up.  Tim's track record bore this out, with consistent IRRs that would rival that of any tippety-top tier venture fund.  The money is returned to the investors (or recycled into new investments quickly), so the investment multiple might be lower than a venture fund.  But, assuming you can put the money to work again and again, an high IRR is the way to measure investments.

I won't go into the nitty gritty details of our strategy, but we certainly found a very strong deal flow of companies that had $4-$40M in annual sales and were at or near cash flow break even.  They were, in most cases, 'equity worthy' but couldn't or didn't want to raise additional equity capital.  Maybe their exsiting synidcate didn't have sufficient capital reserved for the deal.  Or, maybe the company had never raised venture capital and didn't want to start now.  In any event, we proved to ourselves very quickly that this was a viable strategy, and probably with higher caliber companies than we had at first anticipated.

Fund raising in 2009 was, of course, difficult.  Most investors had very limited liquidity to allow them to make new commitments.  And, first time funds always come under scrutiny.  We did find some investors who liked and were looking for venture debt, liked our strategy, our team, and our track record.  But, as chronicled in my 'pulling the plug' post, we couldn't get this over the finish line.  Traditional venture debt strategies tend to have returns that go up and down with VC returns.  They have been out of favor for many investors.  Sempre's strategy has been shown to be much more consistent, but it turned out to not be a benefit to be in the venture debt bucket.

The last chapter of my Sempre story will cover what I am thinking of doing next and why.  Stay tuned.


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