Soaring on Ridgelift

SEC new guidance on FAS 157

2008-10-01T10:36:58-07:00

The SEC aren't waiting for Congress to approve the "bailout" in order to start addressing the issues created by FAS 157. There's an article in today's WSJ – Regulators Ease Securities-Valuation Rules that give some background.

You can also see the tension between easing this regulation and completely suspending it – the clarification allows:

"…executives to use their own financial models and judgment if no market exists or if assets are being sold only at fire-sale prices."

Judgment doesn't necessarily translate into transparency – exactly the issue that FASB was attempting to address with FAS 157 in the first place.

As I said in my last post:

"FAS 157 works fine until you have to contend with an illiquid asset such as a private company stock or (as in the current crisis) mortgage backed securities when the credit market dries up."

It's a challenge to see how to balance this tension – even a full set of disclosures are going to be difficult to investors to interpret. I suspect we'll see such disclosures in future 10-Qs providing an explanation of the "judgment" that has been applied in valuing such assets.

Perfect storm of unintended consequences?

2008-09-29T10:31:09-07:00

As I write this the NYSE is off almost 300 points - the market fretting about spreading "contagion" and the wait for Congress to pass the "Emergency Economic Stabilization Act of 2008" – formerly known as the "Bailout".

While the current Black Swan event continues to unfold I, like many others, struggle to try and understand how this happened – consistent with Nicholas Taleb's definition of a Black Swan event where human nature compels us to ascribe rationale and predictability to unforeseen events.

I suspect that when the dust settles we will find ourselves in the aftermath of a perfect storm of unintended consequences:

A desire to extend home ownership
Declining interest rates as 9/11 and the dot com collapse wrought prior havoc on the economy
Changes in the accounting standards (FAS 157) to provide "better transparency" into asset valuations

Late Friday afternoon, Michael Arrington of TechCrunch offered "How the US Government Engineered the Current Economic Crisis" as he highlighted an article in the NY Times from 1999 where Fannie Mae was under pressure to extend loans to "borrowers whose incomes, credit ratings and savings are not good enough to qualify for conventional loans".

From the graph in the TechCrunch article you can see how US Residential debt grew rapidly, fanned by declining interest rates.

The masked villain in this plot begins to look like FAS 157 – today's newspapers are full of analysis of the "bailout" but there's little mention of sections 132 (Authority to Suspend mark-to-market accounting) or 133 (Study on mark-to-market accounting) – both buried in the 110 page draft of the bailout bill – you can find the full text here.

The Federal Accounting Standards Board (FASB) issues a series of statements that define the framework for GAAP (generally accepted accounting principles) – these in turn are used by accountants and auditors in preparing financial statements. Statement 157 defines how to establish the value of certain assets using so called "mark-to-market" valuations.

Here's a critical element of FAS 157:

"This Statement clarifies that the exchange price is the price in an orderly transaction between market participants to sell the asset or transfer the liability in the market in which the reporting entity would transact for the asset or liability, that is, the principal or most advantageous market for the asset or liability. The transaction to sell the asset or transfer the liability is a hypothetical transaction at the measurement date, considered from the perspective of a market participant that holds the asset or owes the liability. Therefore, the definition focuses on the price that would be received to sell the asset or paid to transfer the liability (an exit price), not the price that would be paid to acquire the asset or received to assume the liability (an entry price)."

I highlight the issue that may be the masked villain. FAS 157 works fine until you have to contend with an illiquid asset such as a private company stock or (as in the current crisis) mortgage backed securities when the credit market dries up.

Pricing assets under these conditions is a lot like trying to catch a falling knife – you have to keep reducing the price to fire sale valuations. The underlying asset may not be impaired but FAS 157 requires you to reduce the valuation to the price you would hypothetically receive in an open market transaction.

If you read the article on briefing.com that I linked to in my last post, FAS 157 is the reason why these assets are being held at heavily discounted values – the institutions holding these assets have had to report an accounting loss as a result. The knife started to fall as the credit market dried up and buyers became concerned (panicked!) about the risk of massive mortgage defaults thus driving prices down.

It's interesting that the proposed bill gives the SEC the power to suspend FAS 157 and also calls for a study to examine the role FAS 157 may have played in the meltdown.

When the dust settles, will anyone have the courage to call the crisis a result of unintended consequences of otherwise good intentions? Somehow I doubt it – Main Street, so poorly informed by the media about the issues behind this crisis is howling for blood… and in an election year, they will surely get it.

Time to pick up the phone…

2008-09-25T08:49:38-07:00

The crisis facing our economy is unprecedented. As former President Bill Clinton said in his interview with Larry King (aired on CNN last night after President Bush's address on the crisis), this is a time for humility – where the true roots of the crisis lie will be hotly debated for years to come. After all, as a true Black Swan event, human nature condemns us to seek a rational explanation… and of course to pin the blame on someone else.

Regardless of how we got here, the crisis has frozen the credit markets – the implications of this illiquidity are dire and need prompt action. Meanwhile our elected officials have turned this into "Wall Street versus Main Street" – a cute moniker but one that ignores the realities that most American's have sizeable exposure to the equities markets.

An opinion poll in today's Wall Street Journal shows that voters expressing an opinion on the "bailout" are divided (33% against, 31% for), not surprising given the complexities of the issues.

Why "bailout" in quotes? To me this is not an issue of saving "Wall Street" by purchasing "bad" assets but instead of restoring liquidity to a frozen market. There have been several articles that do a great job explaining the underlying problem and of pointing out that the Government stands to make a good return for its assumption of the risks. For example, Briefing.com has a great article – "Why the rescue plan can work" and today's Wall Street Journal has an op-ed piece by Andy Kessler – "The Paulson Plan will make money for the Taxpayer" that makes the same point.

President Clinton pointed out to Larry King that the US made money when it "bailed out" Mexico and Chrysler in the past. There's a lot of smart money (including Warren Buffet) that I believe think the same way.

It's appropriate for our representatives to investigate and debate how to structure the plan proposed by the Treasury and Federal Reserve – but that debate can't go on nor get split by partisan politics. So please, get current on the issues, realize that the plan (with safe guards) can be a solid move to unfreeze the credit markets and then pick up the phone and call your representative to tell them you support the plan.

I made my call yesterday.

Surviving the Downburst

2008-09-16T09:17:26-07:00

The latest developments in the US financial markets look like a severe downburst from a severe thunderstorm.

A downburst is the outflow from a thunderstorm that is characterized by a massive downward airflow creating immense hazards for aircraft – a severe downburst can swat even the most powerful aircraft from the sky and create a tragedy.

The failure of Lehman and the acquisition of Merrill Lynch by BoA show the power of the current thunderstorm in the financial markets. No one knows when this will end but in the mean time there is a lot of collateral damage.

We have already seen the market interest in new stock offering (IPO) evaporate. Some investment bankers I've talked to believe that the US won't see a recovery until 2010 and that the IPO market likely remains closed for a long time.

As a result, the number of M&A transactions has fallen dramatically and typical transaction values are low and unappealing to investors and management alike.

I've written in the past about the critical need for early stage companies to conserve their capital and drive aggressively to break even. This latest downburst places even more emphasis on gaining control of your own destiny.

Here are a couple of areas I believe have higher risk in the current environment:

Cleantech investments where the combination of capital requirements and later round pricing creates a mismatch of expectations between investors and management on exit values.
Social media companies where valuations result from growth in user base without strong underlying business fundamentals.

Companies in both these areas will need strong investor syndicates with deep pockets (and willingness to invest yet more capital) or they will fail.

Despite these issues, I still see many new company proposals targeting these areas – time to get real folks! The winners in these areas have left the starting gate – the late wannabes do not get to run.

It's a timely reminder to look for the seeds of the next investment cycle.

The dynamics of innovation

2008-09-02T11:49:30-07:00

A lot has been written over the past few days about Judy Estrin's concern about declining innovation in the USA and Silicon Valley.

While I agree with some of the quoted issues underlying the declined such as the quality of our education system and how the Federal research budget is administered, I (like others it seems) believe that innovation is alive and thriving in the US.

But as the NY Times article quoted Vint Cerf (one of the true fathers of the Internet and now Chief Internet Evangelist at Google):

"There is a remarkable telescoping of vision and an unwillingness to make long term bets."

I think Vint has nailed the true issue on the head – it's not innovation that is declining, it's the way companies are now being built that is the real issue.

Let's step back for a moment and look at the dynamics of the late 90's – the run up to the Internet bubble…

The vision of the Internet was being embraced by everyone – the "new frontier" effect with lots of opportunity and "real estate" for expansion.
The threat of Y2K was top of mind for every IT executive – "we need this for Y2K" was almost a blank check for IT spending.
The impact of PCs, software and communications on productivity was becoming clear. Some pundits even used "ever increasing" productivity as a counter to Alan Greenspan's "irrational exuberance" concerns about the rapid growth of the stock market.
Corporate demands to address Y2K and productivity were poorly met by incumbent vendors making it much easier for startups to sell into the Enterprise.
The stock market was on fire – there was tremendous appetite for new stock offerings (IPOs) that tapped into the opportunities of the "new worlds" of the Internet and productivity improvements.
VC's has plenty of capital, the cycle time for investments to exit had seldom (never?) been shorter (2 years!) and as a result, VC returns were off the charts.

In short, times were great and growth was fueled by a confluence of drivers (Internet, Y2K and productivity improvements).

Back to today – we're faced with almost the polar opposites of most of these factors…

The Internet has been widely adopted by the enterprise.
Y2K was a non-event.
The low hanging opportunities for productivity improvements are gone.
The Enterprise buyer is back to being very conservative and a startup now has a very hard time selling into the Enterprise. This has driven up the cost of sales and the time to complete a sales process – all consuming more capital for the startup.
The current economic mess has further dampened the appetite (and budgets!) for buying new products and essentially shut the IPO market. M&A exists are down in number and exit value.
VC's still have plenty of capital but the time from initial investment to exit continues to climb and is now averaging about 7 years.

Most VCs will tell you that times of economic turmoil set the ground work for the next wave of dominant players to emerge – this means being optimistic about the future and making investments in early stage companies despite the likely 7+ years it will take to grown them to a decent exit.

Meanwhile, the pressure to generate returns has driven a larger percentage of dollars and focus to later stage (more mature companies already well into revenue) investments or to companies with accelerating growth in a belief that this will lead to a high priced (nearer term) M&A.

For these latter investments, accelerating growth doesn't have to show as revenue – in many ways we are back to counting eyeballs, page views and the number of concurrent users. The investment is made on the thesis that the path to monetization will be found along the way – perhaps through advertising or by carving out a big enough piece of real estate that an existing player will pay up so that they can use their own monetization process. This works some of the time…

As a result, it's much harder for a raw startup to raise capital from the VCs or angel investors when they are proposing to build a new product that will take a couple of years to reach the market and then even more years to build up meaningful revenue.

Mindful of these dynamics, the entrepreneur adapts… and turns their focus to leveraging cloud computing, Google AppEngine, Amazon Web Services etc. to build a much simpler and focused software company. Less capital is required so the entrepreneur can finance the company themselves or through friends and family. If the entrepreneur picks the right problem to solve and leverages the Internet for everything (distributed development, open source, marketing, buzz…), it's possible to generate rapid growth.

So innovation isn't declining, its dynamics have simply adapted to the current environment.

Time to be a contrarian – when everyone turns their attention to the short term there are indeed opportunities for a big long term play. The trick is to focus on the magnitude and prevalence of the problem you set out to solve – then apply innovation to build the solution. Leverage the dynamics of innovation in your favor!

So please, it's TIME TO THINK BIG!!!

Thoughts on iPhone apps

2008-07-24T12:14:37-07:00

Blogging some thoughts live from MobileBeat 2008 at the PlugandPlay tech center in Sunnyvale, CA...

It's been an interesting couple of weeks looking at the first set of iPhone applications. Already we've seen a similar dynamic to apps on Facebook - a small number of popular apps with download numbers orders of magnitude higher than the rest.

In common with FB apps, the average price for an IPhone app is close to free - begging the question "how does anyone beside the device manufacturer or the wireless carrier make money?"

For sure we're early in the mass adoption of mobile apps but I see some interesting veins of value to pursue.

1. Applications that deliver their real value via a service. The app is free and provides the portal to the service leveraging portable peripherals (GPS, camera etc.) plus compute and storage resources.

2. Applications that collapse the function of other devices onto the phone. For example, I got an email today from one of my blog readers who had purchased a $2 app for recording voice notes rather than carrying yet another device (and paying someone else yet another $40+). But you still need to think of the back end service...

3. Apps that bind the manufacturer closer to their user - think of the relationship that you can build... Some examples, Microsoft XBox and XBox Live, Amazon with Kindle and Apple with iPod/iPhone with ITunes.

This last vein is applicable beyond mobile as it creates a more durable link to the end user for selling the next device and delivering up-sell or cross-sell revenue.

That's a significant margin improvement opportunity in a space where price/feature wars prevail.

Withering M&A?

2008-07-09T16:38:37-07:00

Just in case you needed more reinforcement of my point from yesterday…

"…the emphasis is on results and driving hard to self-sufficiency. In other words, spend each dollar like it's your last and place all your attention on getting to break even. "

This month has been marked with a heavy ration of venture capital "doom and gloom"… It's hard to miss between the NVCA press release announcing

"…for the first time since 1978, there were no venture-backed IPOs in the second quarter of 2008…"

or…

"VC's a glum bunch over economy, lack of exits."

Indeed, the NVCA press release shows not only a drought of IPOs but a substantial drop in the number of M&A events as well. If the second half of 2008 is anything like the first, we're on track for the worst M&A year since 1999 as far as I can tell.

The cause of the drop-off in M&A activity can be partially laid on the economy – public companies don't acquire when…

They are really concerned about their own expenses and profit – in this kind of market the target company better be break even or profitable otherwise the acquirer's own earnings are going to be negatively impacted and their stock will get hit.
They believe their own stock is seriously undervalued.

But I think there is another root cause that needs to be considered…

Take a look at the number of M&A deals in each year compared with the number of deals where the M&A VALUE WAS DISCLOSED:

I took the numbers from the different reports linked above and then annualized the 2008 number as an estimate for the total year. The percentage of deals with disclosed values has dropped to 35% based on the first half of 2008 after running at a rough average of 50% over the rest of the data. I believe that in general, M&A values get disclosed unless either the buyer or the seller have a reason to want to keep the number private – generally because either the buyer paid too much (not likely here!) or the seller was embarrassed at the price paid (usually where paid in capital is >> than the exit value!).

The precipitous drop in disclosed values suggests a significant number of the M&A events this year were less than happy results.

Like any other sale, M&A only occurs when a buyer and seller agree on the same price - so I think there are a couple of other points to consider when thinking about the current decline in M&A events:

M&A events don't take place when the seller is very unhappy with the sale price and they either have more capital to invest in the company or the company is self-sufficient (enough cash in the bank to give a long runway or breakeven/profitable).
The would-be seller believes their company is undervalued and a better exit can be achieved with more time.

To me this just places even more of a premium on results and execution. Be in control of your own destiny or life will be unhappy.

Food for thought and the last flogging of this point for a while…

Global Surplus

2008-07-08T11:20:27-07:00

Remember the story about King Midas? Everything he touched turned to gold… even his food and then to his ultimate misery, his beloved daughter. It's always struck me as ironic that Forbes Magazine calls their annual VC ratings "The Midas List" as a testimony to the wealth creation effect. The real Midas story was about the realization of life's true riches – I guess Forbes only read the first part of the story!

In a modern day echo of the story of King Midas, the global economy can't produce enough food to feed everyone, demand for oil seemingly outstrips supply leading to higher and higher oil prices but we have been able to create one resource in abundant excess…

CAPITAL.

Seemingly endless tsunamis of capital slosh around the global bath tub seeking opportunities to invest and generate a return. I first blogged about the impacts of excess capital in January of last year – re-reading that post makes me pause for thought - $6/gallon for gasoline doesn't seem so farfetched as it did 18 months ago!

The impact of too much capital can be as devastating as too little…

2000	$100B flows into venture capital funds. ~50% of every dollar was eventually written off. Excess capital continues to flow into venture funds resulting in reduced returns and unhappy investors who now question whether venture capital is still meaningful as an investment category.
2006/7	Capital pours into LBO funds - $255B in 2006, $302B in 2007 – mega-deals abounded until the credit crunch began in mid 2007.
2007/8/…	Sub-prime mortgage disaster. Near-death experience for the banks, huge write-downs, failing confidence in the financial industry.

Yet despite the destruction of so much wealth, capital continues to pour in. Why? As one limited partner summed it up to me in a conversation the other week:

"There are numerous challenges facing both LPs and GPs, but they are generally the same recurring themes of the past in different form. The real challenge this time is the massive excess of dollars seeking returns without the requisite increase in opportunities."

Increase in the number of opportunities? I'm not so sure that it's a lack of opportunities as it is about investor confidence being positive about the future. With falling stock prices, the loss of consumer confidence, soaring oil prices and a closed exit environment, its dark and gloomy and hardly conducive to optimism.

Conventional wisdom has it that Bear markets end when everyone capitulates and throws in the towel. That same wisdom says that you can only spot the end AFTER it happens – through hindsight. The bottom line... No one can predict the point at which optimism returns.

A lack of investor confidence has a direct impact on the startup world – initial capital is harder to get, the bar to raise follow-on capital gets pushed even higher – the emphasis is on results and driving hard to self-sufficiency. In other words, spend each dollar like it's your last and place all your attention on getting to break even.

Above all, don't succumb to the gloom and doom – every Bear market has an end (eventually!) and investor confidence will return. Just make sure that you're around to benefit from the return of optimism!

Sway

2008-06-26T12:58:18-07:00

One of the books I read during my vacation was "Sway" by Ori and Rom Brafman. I'd previously read "The Starfish and the Spider" which Ori co-authored with Rod Beckstrom a little more than a year ago and so I was looking forward to reading the new book.

Sway is well worth a read – it deals with how our decision making process is influenced by external factors and behavior. Two of the studies in Sway really resonated for me.

The first covers the realities of hiring people and the pitfalls of standard interview questions. Most interview questions are hopeless in really figuring out whether the candidate is a good match for the job and the case study drills this home. If you really want to get an insight into a candidate, one of the best ways I've found is to use work sampling – get the candidate to participate in generating a meaningful work product that is relevant to role you need them to play in the company. This requires a time commitment by both the company and candidate but it will give you a tremendous insight into how the person thinks, reacts and fits in with team chemistry.

The second is a very interesting discussion on how the US Supreme Court makes decisions and the criticality of a dissenting opinion to keep the process intellectually honest. Sway devotes a complete chapter to this study and its highly relevant to the decision making process within a company – both at the executive staff level and the board level.

Sway is a quick read… once you nail down the time to open the book!

Mobile Open Source doesn’t bring down the garden wall

2008-06-25T10:59:54-07:00

As expected there have been a lot of articles posted about Nokia's acquisition and decision to open source Symbian, one of the older operating systems for cellular devices. There's a good review of the different contenders for "king of the mobile hill" on TechCrunch if you are interested.

Making the operating system "open source" doesn't change the dynamics of deploying mobile applications. Like it or not, the wireless carriers still have the whip hand when it comes to controlling the applications that run on the phone. It's still a walled garden.

I'm more hopeful about the iPhone and its impact to provide a more accessible platform for application developers. There are still a lot of limitations about what the application can do but it's a step in the right direction. I'd love to see Google's Android deployed but it's certainly taking a long time to see the light of day.

Unfortunately there aren't a lot of incentives for the wireless carriers to open the flood gates for new applications – especially those applications where the carrier doesn't see incremental revenue. More data on the wireless network means contention for bandwidth and cell slots for voice calls – system busy or dropped voice calls are more irritating to the customer and historically have been one of the primary drivers of subscriber churn.

I'm sure the lessons from the wireline world aren't lost on the wireless carriers (especially since most of them have wireline networks of their own) – in the limit, moving bits is a commodity business and the lowest cost provider wins. Being the lowest cost provider requires operational excellence and smart deployment of capital – always balancing capacity against costs. In the wireless world, this is even harder – so none of the wireless carriers are in a hurry to see a repeat performance.

What will it take to bring down the walls? My guess is that one of the weaker carriers will make a death or glory decision to open up and hope that enough compelling applications get deployed on their phones to build back their customer base. As much as Google may hope that new spectrum sales by the FCC with an "open" requirement will drive change, the capital to build out a nationwide footprint is a big nut to crack – if it happens, it will take years to make a dent.

In the meantime, we're left with RIM and the iPhone as deployment platforms – still a big enough customer base to provide a spring board for new applications but just like applications on Facebook, it's likely that only a handful of applications will win big. The key will be picking the RIGHT applications – an area I'm spending a lot of time on at the moment.

Expect the "walls to come tumbling down" slowly…