VC Confidential

Chicago Honors Katrina The Hard Way

On August 23rd, ironically on the second anniversary of Hurricane Katrina, a tornado hit the western Chicago suburbs and a micro burst swung through the northern suburbs where I live and work. By the time the storm had passed with its 70+ mph winds, Winnetka looked like a scene out of the movie, Twister.  Nearly every third or fourth street was shut down due to fallen trees and crushed cars.

Being the bright, proactive venture capitalist, I had installed a backup battery on our sump pump in case power went out during a storm. It worked perfectly for the first 6 hours. Unfortunately, we lost power for over 2 days. Like with my portfolio companies, another lesson learned...  Most of the North Shore of Chicago is going out and buying the propane driven generators for their houses albeit a bit late.

These two poor cars were passing when a tree (about 2 feet in diameter) snapped in half, was carried up and over 10 feet by the wind and dropped down crushing both cars.

Rain came down faster than any time in Winnetka history, flooding many houses and streets.

This three foot diameter tree was snapped in half like a twig and blocked our street.

Just about one in four trees along major streets either snapped or were pulled out of the ground like the one below across the street from our house.

Our golf club lost over 100 trees including this tree on the 10th hole. This Willow has a 12+ foot root system. It was blown over, crushing the paddle court and two cars behind it.

Having gone through a "gentle" version of a disaster, I can better appreciate what New Orleans went through two years ago. Basements are ruined throughout town due to fresh water, not the salt water that submerged much of the city for weeks. We had 70+ mph winds that ripped up trees versus the 175 mph winds that tore off roofs and destroyed buildings. And, we were out of power for a couple of days while they were down for months in some parts. It was quite a surreal 4 days for us but things have gotten back to normal pretty quickly. New Orleans is not so lucky, having gone from the 16th largest city in the US (nearly 500,000 people) to just over 220,000 today.

No global warming Mr Bush????

Business Musings From Carter Cast

I was having breakfast the other day with a friend of mine, Carter Cast, and we were discussing the dynamics and effort necessary to successful build an entrepreneurial company into a larger organization. Carter is a great guy and well known for his balanced approach to management and the effort he spends on building effective teams. Over the years, he has been head of marketing for Blue Nile (one of the first 5 employees), CMO of eBay and CEO of Walmart.com. He mentioned that he has a set of principles that govern him which he shares with employees when he comes into a company. He is a big fan of transparency and believes if employees have clear understanding of the rules of the game, they are more productive. He has captured them in a short, one page document "A Few Musings on Business Life" which he hands out to his team. I've attached the Word doc, but the content is below. (Download carter_cast_musing_on_business_life.doc )

                                              

A Few Musings on Business Life

1.    Integrity
•    “Honesty” usually comes to mind when you hear the word “integrity” but it’s more than that. It’s also “candor” and “managerial courage”—saying what needs to be said for the good of the business or for a person’s development. By the way, anyone can say, “I emphatically and categorically disagree with you.” The challenge is to say it with a little finesse, communicating what needs to be said clearly yet tactfully.

2.    Managing people
•    If you let people know you care about them and want to develop them, they’ll reward you by cutting you some slack--they’ll look past your foibles.
•    Listen, not only to what’s being said, but how it’s being said. Ask questions—actively listen.
•    Don’t underestimate a person’s bias toward self-interest. Saying that isn’t harsh, merely human. We see things from our own vantage point. We’re all trying to survive and thrive in the concrete jungle. So put yourself in the other person’s shoes as much as humanly possible to understand what they’re going through, what they need, and what they aspire to.

3.    Productivity
•    Congratulations on working hard, but working smart is more sensible. Organize your day, have a game plan to maximize your productivity and ask yourself, “Am I focusing on the key activities that will move the needle?”
•    Don’t be afraid to show your passion. Be intense. Be demonstrative. It creates energy.
•    Ignore the noise. Don’t get head rot. Generally, other people’s gripes are…other people’s gripes. Anyone can see what’s wrong. How many can see what’s possible?

4.    Learning
•    Take the time to become an expert in your area. As long as you learn, you’ll progress. Don’t worry about titles and promotions. If you focus on learning, the promotions will take care of themselves.
•    Learn the value chain. There’s no substitute for knowing how it all fits together and what activities drive organizational value. It will lead to good decision-making and will also give you credibility in the organization.

5.    Communication
•    Business is a complex set of interdependencies. Few good decisions are made in a vacuum. Solicit input. Shop your agenda. Get out of your cube for goodness sakes.
•    Communicate a consistent agenda. I suppose that’s the Reagan Rule.
•    Get to know the agenda of others—especially those outside your department. Take them to lunch.
•    Put yourself in the other person’s shoes when encountering conflict.

6.    Zoom in, pull back
•    Details matter—the trick is figuring out which you need to make the call.
•    Don’t ignore Malcolm Gladwell’s notion of “thin-slicing.” Listen to your immediate reaction to things.
•    Sit and stare at the wall—it doesn’t mean you’re not working. Throw assumptions out the window and reconceptualize the business.
•    Monitor the marketplace. Most great ideas are borrowed.

7.    Have fun
•    When you’re loose, creativity blooms.
•    We work for 10+ hours a day. I’d rather sashay, not shuffle through it.
•    Work is more fun when you’re optimistic.

Too Much Information

I am increasingly coming to the conclusion that it is temperament & emotional behavior and not intelligence/insight that drives the majority of successful investing.  Knowing common behavioral traps and being aware of your own behavior is key to becoming a truly successful investor.

Excessively relying on information is one of the behavioral traps that researchers are increasingly focusing their efforts on.  As the amount of information rises around an investment decision, the greater the likelihood that noise will crowd out core signal in the process. In fact, with studies on genius, research has shown that experts do not necessarily process information more quickly than any of us, but rather they simply and cut noise out more effectively. They use pattern recognition to quickly cull options and focus on the most relevant.

Michael Mauboussin of Legg Mason is one of the more interesting writers in the investment circles. His partner, Bill Miller, is one of the most reknowned investors in the world for having beaten the markets for 13 straight years (just missed last year). He has published two interesting pieces on investment approaches and psychology. I will write later about his second one, Turtles in Omaha.

Michael recently wrote about the impact of information on horseracing results. The handicappers grew increasingly confident in their rankings as they were given more & more information. The irony, however, is that their predictions deteriorated as they moved from having 5 pieces of information to 40 pieces. So, they became more confident in their results just as they were getting worse.

I have always been amazed by the simplicity of Warren Buffett's approach. He does not have seas of analysts (I don't believe he may have any) nor does he do excessively deep diligence dives into companies. He becomes "competent" in certain areas and, though he doesn't mention this much, leverages the opinion of key people he knows in each area. This is also why you often see investors have repeated hits in a given area. They are able to determine who has the most reliable and relevant networks in a given field and use them to accelerate decisions.

For many investors, they develop a gut feel for an opportunity and then leverage data points to confirm that feeling. Some are quantitatively driven in the hedge world but this is not really possible on the venture side due to the immaturity of many business models. Overall, what this says is that good investors are those that can determine effectively what are the key pieces of information versus gaining access to the broadest array of information. Furthermore, it provides a warning to investors that having more information is not always (some would say usually the opposite) a good thing and to not take comfort in masses of numbers and facts. In the end, it is the simple core things and your network of people that makes the difference.

Term Sheet 101: Preference

Nearly all VC’s use convertible preferred stock as their vehicle of choice. Most entrepreneurs know this but many don’t fully understand the different flavors and elements of it.

Preference refers generally to the seniority of a given class of stock versus others. Preferred A stock usually gets paid back before common and follow-on Preferred issuances (B, C, D, etc) usually have seniority over both the A and common. This means that the investors will get their capital out before the entrepreneur and team usually.

There are two primary forms of Preferred stock: straight and participating. Straight convertible preferred stock is an either/or situation. Investors can opt to get their capital back but not participate in further upside (e.g. stay as preferred stock…usually the election in downside scenarios) or they can convert to common and participate alongside management & the entrepreneur. The kick point of this conversion is usually pretty clear. If an investor has put $10m in and has 10% of the company, for any exit that values equity above $100m, they will convert to common. For any exit below, they will stay as preferred.

With participating preferred, investors first get their initial capital out and then participate as common shareholders. So, in the above case, at $100m, the investor would get his/her $10m back and then would get an additional $9m (10% of the remaining $90m). Investors will often use this to hit return targets when having to pay a high initial price.

Some term sheets will include participation multiples where investors get 2x or 3x their capital out before other classes. This usually happens when there is significant preference (invested dollars) in the company and there is gap between when their get their capital back and when they start to participate in the upside.

Dividends also play a role in preference. There are cumulative dividends and “when & as declared by the board” dividends. With cumulative dividends, investors “preference” grows each year at a set rate (say 6%), thereby providing an ongoing discount for the investor. This dividend begins to kick in day one. Other dividends start only “when & as declared by the board”. I have not generally seen many boards vote to trigger a dividend.

New preferred stock can be either senior to previous preferred classes (say the Pref B gets its money before the Pref A) or it can be “pari passu” to them (the Pref B and Pref A have the same seniority and come out pro-rata based on their relative sizes). This term usually does not affect the entrepreneur who is subordinated to both classes but is an investor group matter.

As market conditions tighten, investors look to offset increasingly rockier environments through more aggressive terms. As they get more competitive, terms trend more loosely. Lastly, while earlier investors may lock in strong terms, everything is up for renegotiation when new investors come in. Previous preferred terms can stay in place or, in severe cases, get pushed to common. Participation multiples can be eliminated as can dividends. However, for entrepreneurs looking to use new financings to recut their deals, they should be careful. Earlier investors usually have blocking rights on new capital coming in. Additionally, entrepreneurs that play the sides against the middle (old vs. new investors) will significantly impair their relationship with initial investors if they blatantly play this card.

Preference takes many forms in venture capital. It is critical that entrepreneurs fully understand the implications of the terms they are accepting so that it does not impact future relationships going forward.