Archive for the 'Private Equity' Category

Are you giving equity to your VC to get their advice?

This post comes after a discussion through comments with Fred Destin on one of his recent posts. This is something I’ve been thinking for a long time, and I just thought it may be time for me to put this on paper: Nothing in the way term sheets are crafted creates an incentive for any of both parties to value advice from investors.

Let me just state first that I’m not saying that some VCs or BAs are not adding value to companies they’ve invested in. I know Fred and he’s definitely a nice fellow and very proactive investor, he’s for example participating in a lot of initiatives like Seedcamp. But, my point is that VCs or BAs are best viewed as pure financiers with the incentive structure put in place through current shareholder agreements: Their added value is in putting money in the projects that will be providing the best returns – with or without them on board.

Today, once the money has been committed, there is no incentive for the entrepreneurs to listen to investors’ advice – entrepreneurs are not paying for it. Furthermore, there is no incentive for investors to put extra skin in the game – if they do, other investors will benefit from these freebies on the same terms than they will.

OK, we regularly do see some investors providing extra help. But for me, their incentive belongs to either empathy or reputation management (providing value now to get a discount on future financing rounds with other startups). The carried interest, that is often cited, is not actually a hard incentive. Investors will receive it, whether or not they were really instrumental in the success of the company. Sure, investors have an incentive not to let the company fail, but the way to “fix” a company is certainly something that is not widely shared between entrepreneurs and investors, and I don’t think entrepreneurs see them as advice they have paid for when they issued equities.

So my whole point to entrepreneurs is that they should not expect particular help from VCs or BAs. Sure, they will get some “free” advice, but like everything that is free, you may like it or not, it may even have a lot of value for you, but you can not complain on the quality.

I’m actually thinking that we need alternate incentive structures so that entrepreneurs do pay for advice that have value for the project. There is a problem of assymetry in information products like advice, it is that you don’t know the value until you’ve consumed them, and when you’ve consumed them for free, you have litlle binding to pay their full value. My current thinking is that alternative currencies may be a good way to solve this problem: You can imagine that projects will be able to issue local currencies that will be backed someday by actual shares of the profit. But this is another story, a subject for another post…

Should I give an arm and a leg to the VCs?

Bringing VCs on board can be an emotional (and sometimes traumatic) experience. It always seems that you’re giving a lot for what seems little in return: cash. Using simple maths may prove a powerful tool to set some context before taking the dreadful decision of accepting foreigners’ money. In this case, we can rely on the notion of discount rate to shed some light to the debate.

 Let’s first take the theoritical case of a startup doing a seed round of €500k on Year 1, a first round of €2M on Year 2, a second round of €6M on Year 3, a mezzanine round of €2M on Year 4 and a brilliant exit of €30M on Year 5. If VCs use a discount rate of 50% to define the shares they want with a target exit of €30M, they’ll dilute you from 100% ownership to 91.5% after seed-round, 71% after first round, 39% after second round (ouch!) and leaving you 35.1% ownership of the company after mezzanine round (where we keeped a 50% rate for the sake of simplicity). So you’ll end up with €10.5M in Year 5.

Not bad! But wouldn’t have you been better not taking VCs’ money and maybe take 10 years to exit with 100% of the final €30M? This is where using discount rate can bring some rationale to the decision. Let’s forget all the details of the different rounds that were there just to set the stage for: am I better owning 35% of the exit value in Year 5 or owning the entire exit value in Year 10? This is where it all depends on your own discount rate. If your own way to assume the discount you apply on years between 5 and 10 is below 23.3%, then you should go all on your own and shoot for the big prize; just be prepared for a long, long trip. If it is above 23.3%, then settle for the “quick” route and pocket the %35.1 percent faster (still 5 years).

 When we compare this 23.3% with the 50% of the VCs, it could seem obvious that the decision should be: pocket the money on Year 5 and then,..become a VC. In fact, the 50% holds only for specific projects: The successful ones. VCs invest in a portfolio of projects and as the old saying goes: Out of 10 invesment, 5 go down the drain, 2 become zombies (projects with no exits), 2 give back less than what was disbursed and only 1 is a superstar offering the famous 50% or above. All in all, a fund is very happy if it can provide an Internal Rate of Return (IRR) above 12%. So you could assume that you’re finally better off keeping your investment in your own startup and make it blossom at a rate superior to 23.3%. But remember that your investment is tied to one “single” project, and that the risk is exactly what is making the transition from a discount rate to an IRR.

In fact, from an option point of view, it is always very positive to get cash out sooner than latter. What the little example illustrated was just that faster exits are actually made possible by the cash that the VCs bring in: this provides the acceleration needed to reach more rapidly the way out.

So when taking the decision, remember the paradox: Giving an arm and a leg can help me run faster.

Private Capital Markets

The Economist released this week an interesting article on the subject of financial exchanges. This gives a broad view of the sweeping changes currently taking place in the world of capital markets.

I’ve been thinking lately quite a lot on the more specific subject concerning private equity placements and ways to create liquidity. I’ve discovered in the process several places doing interesting things like Entrex or others.

What is striking is that the Market is creating many alternatives to the cumbersome machines that the public exchanges have become: selling shares under limited scrutinity, selling blocks of shares between big players,.. It should be remembered that some of these liberties have progressively and conciously been banned from the public markets to prevent small investors from being abused or having big players acting according their own set of rules. It is also interesting to see that a lot of these are genuine innovations made possible by the advent of new technologies,  better understanding of risks and the creation of clever mechanisms to handle complex contracts.

While the good old public capital markets are becoming more and more global, it should be noted that the population of capital markets at large may be becoming more and more distributed.

Private Equiliquidity

Private Equities have received a lot of attention lately. Due to several reasons I won’t detail in this post, they have a clear advantage in term of costs compared to Public Equities. One thing they definitely miss is the liquidity their public siblings usually enjoy.

I’d like to present on this post an idea I’ve playing with for a while: securitizing pools of private equities to offer liquidity to their holders. The schema would go like this: You first create a vehicle on a pool of private companies within a specific sector, industry. The administrators of the vehicle then acts as market makers for the different companies, issueing shares of the vehicle in exchange of private shares on bids and asks terms. The vehicle itself is traded on a public market, offering the liquidity private investors are seeking after they exchanged their shares against securities of the vehicle, then sold these securities on the public market.

There are already funds that are floated on public markets. They offer to their investors the liquidity they would miss otherwise. They also offer a good mechanism to assess value of the funds’ portfiolios correcting awkward valuations that accouting principles can sometime  provide on the assets of these funds.

What would be rather novel I think is that people owning private shares would actually invest by providing their shares to the vehicle. With a continuous market making from the administrators of the vehicle, they would not only gain liquidity, but also a continuous valuation of their shares against the shares of the vehicle, and public market would provide valuation of the shares of the vehicle for the entire portfolio – something easier to do for public investors.

If you’d like to discuss the subject of private equity and liquidity, please join us within the BarCampBank where we exchange ideas on these topics and many others.

Private Equity going Public

OK, I’m not speaking of a company privately owned that would filled for an IPO; although it is interesting to note that most of the attention lately has been on the reverse moves. I’m speaking of Blackstone intention to float their shares.

The move is interesting first because Blackstone is one of the biggest Private Equity firm in the world. Second because it could usher a new state of the art in Private Equity. A lot of the major Private Equity firms will soon face the same dilema: how to you turn from a small boutique who’s grown huge into a well-run professional company. Buy-Out firms, does this remind you something? The fact is that a lot of the current biggest PE firms have been founded in the last half-century by a bunch of financial entrepreneurs. A lot of these entrepreneurs are now reaching an age where most of the people already retired. So you have to solve a transition problem.

I find interesting that Blackstone decided to turn to the Public Market to solve this cash-out / maturity conundrum. I would find even more inspiring if the Carlyles of this world decided to turn Blackstone back from Public to Private in order to boost performance after a while; and educating if a Carlyle gone public ends-up merging with our frontrunner Blackstone.

Private Equity backing serial Movie Directors

A recent article in The Economist called Hollywood’s new model (premium access required) is reporting the interesting trend that Hollywood film funding is taking more and more the private equity approach. Apparently some funds found an opportunity to change the investment process in Tinseltown and take their profits out of a risky business by applying some standard methods: bank on the directors with a track record (even slightly tainted), be ready to invest in unproven ones (if they are cheap). This notably differs from the old investment process: do not be seen with a looser, do not bank on the unbankable. But this clearly resembles the methods applied in high-tech: backing an entrepreneur with a mixed record is better than backing a rookie (if he is cheap), banking on a rookie is an alternative (if he is really cheap).

 Maybe Entrepreneurs will never enjoy the glamorous lives of movie directors marrying their gorgeous lead actress but they may take some comfort in thinking they do not have to invite the board to their wedding party.

Is Private Equity a better Chief?

The latest deal in Private Equity with the acquisition of TXU by KKR and Texas Pacific Group is giving an interesting new twist in the battle between private and public control. More specifically it raises the interesting question to know if private can be better than public for governance.

 True, this is not entirely new. The raiders of the 80s were clearly showing up where management was a disaster, would sack the guilty, put some order in the accounts and take their profit and leave. This some kind of ruthless governance, but this can be extremely powerful to take advantage of the erring companies. Then, eh, this is the public governance that clearly failed to do its job.

 Arguably, such opportunities are scarcer nowadays as public has stepped up its standards. So came second wave of private equity: take advantage of the difference in regulation. With post-Enron’s ajustments, it seems it is now less costly to run a company under a private umbrella rather in public full ligth. Thus a series of public to private transformation. PE would then monitor the business for a couple of years, then return the acquired company to the public with a profit, or more likely sell it to a bigger group. There is certainly more governance in this, than in the previous round. But PE was still supposed to be fairly hands-off after some initial restructuring beyond the public’s eyes. The job was again monitoring that everything was going according to plan, if not: sack the management team.

 The new deal with TXU is interesting, because here PE clearly is clearly boasting its capacity to provide better governance on the long term. The argument is even, public market are short-sighted (not a new complaint), we will be able to drive with our eyes on the silver lining and profit will come, eventually. We will have to wait a couple of test for the acid test, but there’s enough default in public governance that give weight to the argument.

 Now, what could be the next step. More private? The answer could in fact be more of both. With peer-to-peer (P2P) governance we could indeed see a fourth wave where control returns to the larger number but possibly not through the standard public markets mechanism. It is certainly a shame that the collective brain power of all these small investors is not currently used for governing companies. It is obvious now that the bloggers have a collective power way beyond the Gartners and Forresters. We have technologies so that governance can now be expressed through web technologies instead through proxy fights and dubious shareholder meetings. The same for the accumulated industry knowledge distributed through potential small investors instead of in the heads of a handful of PE specialists. So there is obviously an opportunity to tap into this wealth of capacities.

 I don’t know if this will happen, but I would find quite funny that P2P governance comes to be a credible alternative and that everybody would wonder if the Ps stand for Private or Public.

Maybe you could join us on the BarCampBank if you’re interested in discussing this.