Fausto Boni @ 360°

What Investors’ really want.

When I recently met with a long time colleague VC as well as a shareholder in our latest fund I expressed some surprise and frustration for the seemingly irrelevant correlation between a fund’s IRR and its perceived performance.

My colleague looked at me in disbelief and politely told me I wasn’t at all getting it: “Fausto !” he said “you’ve been in this for so long and you still don’t realize investors don’t really care about performance as much as they care about glamour ?!”

In fact looking at our past individual investments, rarely the best ones in IRR terms are those we are indentified with or praised for. Many colleague of ours have since long understood it and some are ready to pay whatever price is needed to get into so called “high profile deals”: chances are (that’s the underlying reasoning) that this one is going to be a superstar company and  we’ll be identified as their backers by their investors and target companies. When did they enter and at what price and what return we’ve made on its quickly going to became a minor detail.

While such a cynic behaviour can be understood (even if not entirely justified) from professional Venture Capital firms which have to find ways to market themselves every 3-4 year at each fundraising cycle, much more puzzling is the behaviour of private investors who supposedly invest their own money. In a rationale world they shouldn care about whether they invest in a boring business or in a fashionable one. However this isn't a rationale world as anybody can see by looking at the current private placement of Facebook’s shares currently managed by Goldman Sachs to the benefit of their “best ?!” private clients.

The Placement:

To provide its wealthy clients the “privilege” of getting a piece of the hottest technology/media company of the decade, Goldman Sachs charges them a 4% entry commission (probably on top of the 1% per year they already pay on any asset managed by the bank). On top of the 4% entry charge clients will be charged an extra 5% on any profit made on such a fantastic investment... which by the way values the company “only” USD 56 Billions (2 times Google’s valuation at IPO).

In addition it is rumoured the privileged ones are requested to lockup their investments for 2 years and to have a substantially high level of assets in the bank’s accounts.

Chances are that thanks to this investment (even if not formally guaranteed) Goldman will also win the mandate as lead manager/book runner or Facebook’s IP and make another 2 - 3% fee on a 20 Billion + placement.

In summary likely payoff of the deal for all parties is:

Goldman’s client: In order to make a 10% return per annum on the deal (a real minimum for an investment in a private company at this stage) Facebook’s valuation two years from now must reach USD 71 Billions. Is it feasible ? probably yes (shares in grey market seem to increase by 10% a week..). Is this easily achievable ? not too convinced

Goldman: in exchange for holding the shares on their books for a couple of months (invested capital USD 1,5 Billion) in the same scenario outlined for their client above Goldman receives the following fees: Placing : 60 Mio, Profit Share 15 Mio, IPO fees 400 mio (assuming 2% fee on a 20 Bio placement 12 month after) IRR 157%, if we take out the IPO fees a more than respectable 30%

 

The Company

I'm Personally a great fan of Facebook and its business, even at a valuation 1/5^th of the current this would make it one of the greatest ever successes in technology and venture capital. Great credit and praise to his founder and early stage investors!

On January 10^th the FT published the numbers circulated by Goldman to their beloved clients for the first 9 months of 2010 : Revenues USD 1,2 bio Net Profit of USD 355 mio. To increase the appetite a comparison with 2004 Google’s numbers have been made (Revenues 2.0 Bio and Net profits of USD 195 mio). Google’s current market cap being at USD 200 Bio (vs 23 Bio at IPO) makes Facebook’s a real bargain (for their clients in Goldman’s view).

FB has currently 500 Mio registered accounts to which he serves advertising. About 120 Mio of those registered accounts are active every month and in last month on average they spent on FB 7 hours of their time. Those are by any mean very impressive numbers and past growth has been extraordinary and will continue for some time.

Looking at valuation metrics lets now assume that FB’s net profits (post or pre tax not given to say, probably the numbers coincide as previous loss carryover offset those charges.... given the company isn’t public this isn’t a known data) for the year are at USD 550 Mio, current valuation of the company shows a P/E of above 100: To reach a normalized historical P/E of 17 or Google’s more aggressive P/E of 25 company should multiply its profits by 4 or 6 times for their latest investors to breakeven.

Feasible certainly but not a given. At constant revenues per minute spent by user that would require for example users to double in number and to double the hours they spent of FB too.  

In my view FB has indeed the potential to get there and beyond in the long term, but I’m not convinced entering now at those terms is an highly attractive risk reward profile (except for bankers handling the placement of course). Why then private investors fight to get a piece of it ? Well probably in those calculations I haven't factored in the value of being able to claim in the next 20 years during dinners and cocktail parties to have been a Facebook's backer before the masses...

 

Recession’s Impact on VCs (cont…)

In my post last fall I made a point on the relatively lower impact of the current macroeconomic situation on VCs vs other categories of investors. While some (entrepreneurs in particular) broadly agreed with my position I believe most others (GPs of private equity firms and LPs) smiled sarcastically (and still do) whenever I reply “not too bad” at the usual “how is business doing ?” questioning.

 

A few months of recession and bear market allowed me to rethink about the whole issue, backed by some stronger evidences provided by performance metrics of some of my new and old investments.

 

The short conclusion is that many top performing companies with strong value proposition ARE NOT suffering but are benefitting from it. Examples (from my portfolio companies):

 

- Yoox (www.yoox.com -  worldwide leader in off/on season online fashion apparel and accessories): an heated debate between investors and CEO took place in October as VCs (with different degree of cautiousness), invited to plan for a bearish scenario of minimal to negative YoY growth while CEO stated he did expect the company to maintain the forecasted 40% YoY growth. 5 month later company’s performance proved CEO’s prediction was completely accurate. Not only Xmas season was stronger than ever but also Q1 09 started on the same pace. Conclusion: ecommerce growth driven by stronger fundamentals and not connected to few points of GDP growth.  Good value for money researched more than ever by customers in recession times makes company’s outlook very bright.

 

- Mutuionline (www.mutuionline.it  - Italian leader in online mortgage and lending brokerage): with banks in deep crisis and real estate market stalling even the most optimistic investor would have expected a strong contraction in volumes of the brokerage division. Instead volumes of new applications keeps raising since October very strongly on a YoY basis. Reasons ?: familiarity with web based instrument of the relevant age groups, word of mouth, banks not able anymore to match competitors’ offers.

 

Companies having more difficult times are those serving the B2B market where in many case Capex decisions are often delayed thus extending already long sales cycles. Nevertheless I keep believing  that their ultimate success will depend more on them being able to make a very solid investment case for themselves. If they do, then, sooner or later, they’ll fund a budget pocket. If they don’t it would be very unlikely that a return to positive growth will translate in a market opening for them.

 

The above of course doesn’t imply that we and our LPs will be better off if we remain for long in a deep recession. In an uncertain scenario M&A activity is reduced, as general willingness of corporate buyer to pay high multiples on targets. Besides appetite for IPO is low to nil and those few stories remaining appealing to investors are such at lower price than 1 or 2 years ago.

 

However I maintain the view that, for those who have the possibility and the patience to wait for better exit markets, possibilities to achieve superior returns remain intact.

 

 

 

 

 

 

Financial Crisis: Impact on Venture Capital and their companies

 

Financial Crisis has been on everybody's mind and mouth in the last few days and weeks and also Venture Capitalists felt the need to analyze the impact of the financial crisis on their world and to spread the word with portfolio companies and co-investors via emails, newsletters, forums, slideshows and blogs which have then been chain forwarded and contributed to spread some kind of sense of urgency but also in my view some further unnecessary panic.

While it is clearly wise to carefully ponder issues and implications of such crisis on our environment and initiate actions, I found many of the views expressed (also from highly reputable investors/firms) far too extreme. Parallels have been set with the previous financial crisis and in particular with the 2000 "dot com bubble" implosion and some concluded that given that this crisis is likely to be longer and more pervasive than the last one the action to be taken should be even bolder this time.

While we agree on the vaster scope of this crisis versus the last one I encourage to consider that while 8 years ago our ecosystem was the cause and not the victim, here the epicenter of the seism is probably as far away from us as it could possibly be. In fact:

1. Neither our funds nor our portfolio companies are leveraged (they never have been). Hence credit restriction have no direct impact on valuation and riskiness of our assets

2. Our shareholders are (typically) long term investors who have set aside capital with a 10 or 12 year horizon. Ourselves and (hopefully) most of our peers hold reserves to support our portfolio companies in difficult times.

3. Our companies are very early on in their life cycle and plan to grow at 30- 50% year on year. Hence a very minimal part of their growth assumptions can depend on sheer GDP growth.

All the above applies to private companies in early stage of development. Portfolio holdings in more mature companies already public or closer to exit will of course suffer as much as others.

Of course chain effect exists and they are always difficult to predict and if the word falls apart it would be naive to believe we're all in a safe heaven. Our reccomendation therefore is to:

• Increase reserve allocation to portfolio (to decrease for example reliance on co-investors whose liquidity might dry up)

• Raise more money rather than less if possible

• Request prompt scenario planning to portfolio companies

• Variabilize cost as much as possible

• Defer increase in spending until scenario is clearer

At the same time, at least for the moment, we also recommend no panic, no massive layoff (except for situations in which "fat" was already there pre-crisis) and no complete generalized and across the board  spending/investing freeze. We must be aware that if we dismantle fragile early stage organizations to prepare for the worse we might find nothing good is left once the crisis is overcome.

Winning teams

Some investors believe that what makes or break a successful project is almost entirely its leader.

While a true leader is always extremely important I do believe that his ability to attract into the project very early on a group of talented individual is probably the most visible sign of his capacity to be the leader he pretend to be.

While it’s relatively simple to recruit when a venture has traction, 10 million of cash in bank, 3 large VC on board and in the position to offer six figures packages, attracting talented people who might have to leave their jobs for some shares when there is no cash and just a project on paper, is indeed a challenging task. Somebody succeeding in it already deserves respect.

Going forward those 3 or 4 early recruits (even though some might drop or have to be dropped on that road) will certainly help out the founder to keep going in spite of difficult times that sooner or later occur in every start-up. Their loyalty is typically greater as greater will be the sense of responsibility of the founder toward them (more than toward investors indeed). While second waver recruits will come and go, most of them will stay until the end.

This is why when looking at an early stage investment opportunity I like to assess not just “the” leader but the entire founding team.

Confidentiality: a non issue (in 99% of cases)

The level of the confidentiality concerns in the entrepreneurs community is in my view inversely correlated with the level of development of the Venture Capital “ecosystem” in a given country.

Here is a non exhaustive list of reasons why entrepreneurs shouldn’t be too concerned in disclosing their plans to Venture Capitalists:

1)      If you cannot or don’t want to you’ll not be funded. Nobody write checks for “good ideas” that cannot be disclosed (obviously). Also most VCs are willing to sign NDA only if and when they are really interested and realize there is some serious IP needing to be protected (first you need to get them interested).

2)      Venture Capitalists aren’t in the business of starting companies themselves (even if they wanted to I guess most won’t be able to)

3)      Most of the time ideas aren’t that important nor really “that” new and what matter is execution. Execution cannot be copied.

4)      Even if your supposed competitor were aware of what you are doing that wouldn’t matter as much as most entrepreneurs think.

What could happen is that Venture Capitalists might be after information to develop some kind of industry knowledge base. Is such case the risk is that knowledge acquired by looking at your BP or meeting with you, allow the VC to better assess other opportunities they are considering (either simultaneously or in the future). Its not a tragedy and in any case you cannot do much about it.

Most (at least those caring about reputation) will refrain from photocopying your data and give them out to others if they invest in them.

In any case my advise is that if as entrepreneur you have valid reasons to be very deeply concerned about confidentiality you should try to limit your contacts to a reasonably low number of investors and possibly pick those with a solid track record (in term of ethical behaviour).

How to relate with a VC ?

Asked yesterday at a panel in front of several entrepreneurs to elaborate on the “how shall entrepreneurs approach us” I had occasion to think about the subject and realized that this approach is what immediately set me off in looking at different proposals, in particular (sadly) in Italy.

I encouraged the audience to think about the entrepreneur-vc relationship as a journey to wedding (or in any case to a stable /long lasting relationship) with a companion. This is particularly true nowadays when average VC holding times are longer than they were in late nineties for example.

How would you react if somebody you have met on a dating site would email you out of the blue a msg like the following: “Hello, I am a very pretty lady and have many wedding proposals already. I am definitely a high maintenance girl and will only consider man available to guarantee me a budget over a million USD per year for 30% of my time. If you want to discuss in order for your application for the privilege of a meeting to be considered please provide copy of your last paycheque and sign the attached pre-nuptial agreement”. Sounds weird to you ? You wouldn’t imagine how many unsolicited approaches I have every month from people providing only a very minimal description of their business but with a fairly precise description of the terms of the deal they’re ready to accept nevertheless asking you to sign the attached NDA to receive more info.

How would you behave at the end of a first date with somebody you really like to know more ? Would you leave the car without a word and without letting somehow know that you’d be interested in some sort of next step ? Well this happens everyday here. People come, present 40-50 powerpoint slides, finish their presentation, close the book and leave the office almost without a word. Only the smarter ones suggest some kind on next step, outline a process, encourage some kind of due diligence, ask for a kind of feedback. Defining upfront a desired result and a path to it is the key to success in any kind of relationship both personally and professionally. Why should this be different in the Entrepreneurs-VC world ?

Too Ambitious or Too Cautious business plans ?

The level of ambition set in a business plan is the very first test on the level of entrepreneurship of any individual I meet with as a VC.

True entrepreneurs always set (for themselves and their ventures) high level of ambitions. Our job is to challenge them in order to assess their level of “mental sanity” while preserving their drive….particularly if we have already invested in them.

On the opposite wannabe entrepreneurs always fear they would be measured against some kind of budget or plan rather than on wealth creation and typically present you plans incorporating some kind of safety net. Those people sometimes even come to include in their models lines with “contingencies” and in general when challenged one can easily sense that even on topline projections they remained on the conservative side.

Please don’ misread me… I’m not advocating that entrepreneurs should come up with absurdly inflated projections to show their drive and commitment to investors. Particularly since large ambitions on topline are most likely to come with aggressive spending in marketing and overhead the sanity check on the business plan remains a must do well for any VC investor and the “contingency” shall be provided for in the investor’s internal estimates, particularly when one has to estimate a cash out date for a certain round and plan to prepare the next fundraising !

How entrepreneurs should select VCs

The VC selection process is a very tough job for entrepreneurs (and previous round investors)... at least for those who have the privilege to have multiple alternatives in a round of financing (or even better those in situations like this: www.thevc.com/strips/Upside08.html ).

First time entrepreneurs and unexperienced investors tend to underestimate the huge amount of damage and value destruction potential of bad investors. Investors could roughly be classified in 3 groups:

1. Those who know what their are doing and create (or rather help the CEO creating) value by being actively involved.
2. Those declaratively or factually passive who piggyback on management and other investors.
3. Those who know little to nothing about what they (and the business they invest in) are doing but nevertheless feel compelled to intervene and have a say on as many issues as possible.

Goes without saying that 1 - 2 - 3 above are really piramidally clustered with (unfortunately) a very large number of people in group 3. Avoiding 3 investors is in my view much more important than picking 1 vs 2.

I encourage entrepreneurs to do as much as possible first hand due diligence on their investors (and I impose myself the discipline to do it when I'm and investor in previous round). Due diligence means to call up managers and other past co-investors in order to be able to draw up an as much accurate as possible profile of the firm and most importantly of the partner in charge rather than relying on apparent signs such as known brand name or past investment successes (which might be in some case investment made decades ago by completely different individuals).

Of course it is important to be able to interpret and filter such due diligence feedbacks. As the relationship managers-vc and vc to vc isn't always in harmony and sometimes conflicts of interest (and of personality) occur, this isn't an easy task.

Founder or New CEO ?

One of the most debated topics in boardrooms of VC backed early stage companies is certainly the opportunity to (or not to) replace founders with professional CEO at certain stages in the life of a company.

Looking at statistics in my current and past portfolio its appears extremely obvious that companies where the founder-s/ceo-s remained at the helm have (boldly) outperformed the ones in which external CEO have been brought in. Actually only in one case I can remember a very successful investment where a new CEO came on board (though the change took place almost in conjuction with the IPO and the company after initial post IPO successes (and luckily post our exit) performed very poorly).

Of course the stats do not really tell the all story as the samples are necessarily biased. Often when a company faces disaster a new CEO appointment can be the last attempt to save situations which might be impossible saves anyway. On the contrary when a company performs well, more inertial behaviours tend to prevail and investors tend to become much more forgiving and reluctant to change even when a change would be highly beneficial to the company's future prospects.

The conclusion I have come to when thinking about such issue based from past experience (even though on a more qualitative than quantitative basis) is that identifying from the start a founder/ceo and a team that CAN be leading the company until the exit is, particularly in Europe, a must have for at least two reasons:

1. the first 6 months of any startup are decisive to create the core team (the 3-4 people who'll make the difference). Only an outstanding Founder/CEO will be able to attract top people at such stage
2. external CEOs are (generally) eager to jump on board if the outlook is rosy and the IPO 6 months away but also the very first to leave a sinking ship. When this happens besides the financial loss investors end up spending their time in managing the wind-up process.

Copycat deals? Not necessarily a good idea anymore

In 1997, when I got started in the European VC, environment was more difficult and simpler at the same time.

At that time competition was very limited (even though this is still the case today in some geographies such as Italy) but entrepreneurs less "ready" to take the jump and less familiar with how to deal with professional investors.

However because of the less "structured" environment it was relatively easy to discriminate between "good and bad", both in term of people and in term of opportunities. Two years later in the middle of Internet bubble with herds of MBAs, consultants and bankers jumping on the wagon, people assessment started to be much trickier... but the situation got back to normal within a few months as the bubble explosion cleared up the environment of wannabes entrepreneurs.

On the deals side what we have seen constantly in the last 10 years is the dramatic shortening in what I use to call  "time to copy". When we seed funded Selftrade (first independent online broker in France) in late 1997, US based leader ETrade was not only up and running but already public with multibillion market cap. If a VC could cope with the idea that Internet adoption would pickup in Europe it would appear pretty obvious (though many things appear obvious in retrospective…) that Seltrade could be a blockbuster (company eventually IPOed in early 2000 and reached mkt cap in excess of 1,0 Billion).

Today (unfortunately) those copycat deals have become very reare. Internet demographics being more homegeneuos and information flowing faster have almost zeroed this "time to copy". Not only copycats are popping up before a business model is proven from an economic standpoint, in many case they do appear in different continents and countries well before they have even proved to have some kind of traction in term of usage. In many case its enough for a new concept to obtaing just funding from a reputable VC to witness a mushrooming of copycats in other countries.

Consequences of this are twofold:

a) If a VC funds a breaktrough company better to stay silent until ready to push hard on accelerator

b) VCs should be very very careful in funding copycats as many business model will in my view proof to be wrong everywhere (irrespectively of geography).

Fortunatly for us in Europe we are seeing more and more original ideas and b models getting started here….