Tag Archives: investment bubble

A finance purist’s view of artificial markets

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A bubble can only exist in a market. To debate the existence of a value bubble is to presuppose the existence of a market. In a market, motivated buyers and motivated sellers meet, and the more fragmented this market – the deeper and more liquid – the more efficient it is. That is to say, it’s more true, it’s more indicative of buyers’ and sellers’ motivation. (This would not negate the possibility of a bubble, on the contrary, it makes a bubble true.) What we have now, what we have had for some time, is a false market.

Here is the view of one legendary fund manager on the subject: “‘It’s not a free market. It’s not a clean market.’ The Federal Reserve is doing much of the buying of Treasury bonds lately through its ‘quantitative easing’ (QE) program, he points out. ‘The market isn’t saying anything about the future. It’s saying there’s a phony buyer of $19 billion of Treasurys a week.’” Although this observer is referring to the debt market, there are ripple effects. The Fed’s bond purchases is money added to the financial system, and while the complexities of bank capital accounting, currency exchange, money supply measures, and high-frequency trading are too much for the human mind to grasp, especially in unison, $100 billion of artificial supply added each month is straightforward.

And it’s no joke. For perspective, consider: Sequoia’s latest fund, large in its peer group, is $1.3 billion; Apple’s cash balances (as of the latest quarter-end) were about $30 billion; Google’s operating cash flow in the same period was roughly $3 billion; BoNY Mellon’s total balance sheet at the end of 2010 was almost $250 billion. When we think about $100 billion of new investing liquidity added to the system monthly, we are thinking in the realm of almost 100 new Sequoias, a whole bunch of Apples, several dozen Googles – monthly – and a major new bank every quarter. With a small pause in the middle of 2010, it’s been two years now.

In the opinion of another prominent money manager, the Fed’s policy is to promote “good inflation” – or, stated differently, a run-up in stocks – which was of course no secret from the very outset of QE2. (The plan has worked.) That this truly constitutes “good inflation,” however, is to argue that an artificial market, a manipulated market, is a good thing for as long as price levels rise. Far be it from me to speak against rising stock prices, but a false market renders these meaningless, no? I don’t mean that statement, obviously, to diminish actual trades and actual investments made for actual dollars at actual valuations. But in a market in which price levels and liquidity flows are unnatural, there are artificial ripples that lead to fragile consequences and the risk of flawed decisions, that are also actual.

Again, the point here is not to bring up bubbles, because peripheral traits of unreal markets are also illusive, and at least according to my idealistic definition this market is unreal. Raised to believe in market efficiency, educated in the capital asset pricing model, modern portfolio theory, discounted cash flows, weighted average cost of capital, alphas and betas, leveraged betas, and so on, I suppose I am a finance purist. And so my beef is not with any over- or under-valuations, but that the environment in which transactions are taking place is one in which we simply cannot know. Investment judgment, in the era of QE2, is not based on investment fundamentals, but on the analysis of QE2 and its continuation. For the sake of markets, true markets, I am rooting for the program to stop.

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The product, the business and the relativity of exits

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A product is sold, a business is built. A product might support a business, but will always still be a product. A business can be based on a product, or several, but it will have to be much more than the collection alone. A startup may begin with a product, but will have to finish as a business. A business starts as a small business, and becomes bigger or fades. In fading, it is beaten by the bigger, or it is bought, like a product is bought, but for different value. In this sequence from product to small business to larger business, there is not only an order of scope and magnitude but an order of exits – actual or implied.

Let’s define our terms. Exit – noun or verb, depending on circumstance or perspective – at one time known as return of capital, it may now also include return on capital because return of and return on tend to be lumped together in an environment that is small on interest and dividends but big on refinancing (in its variety of forms). By way of further clarification, capital is not necessarily financial but may also reflect other forms of investment. These are not always monetary, although all things are monetary I suppose, on some level, even if capital is invested in the form of time, expertise, process, franchise, and a variety of such assets that add value to a product or a business.

Using this set of purposefully broad definitions, employee salaries are a form of exit. The bigger the salary, the bigger the exit. (I’m sure all bosses know what I’m talking about.) Deferred payment, or stock options, are a deferred exit. Switching to other forms of capital – loans, for example – interest as well as principal are exits of sorts for the lender. Dividends as well as an IPO or a strategic sale are exits – it all really is relative – for an investor. Product sold (i.e., revenues produced) are little exits – or, in some cases, larger ones – for the business that creates the product through investment (in its variety of forms, as described).

Inflows and outflows, inflows and outflows… Money in, money out… Effort in, result out… Entry, and exit… And in context of the progression discussed at the outset of this article – from product to business to bigger business and etc. – now we can see what was meant when a series of exits was mentioned: financially, logistically, in scope, in degree. There is a chain that begins with the first idea and continues with the start-up of an enterprise and for a shorter or longer period thereafter. Early investors are sometimes taken out by later investors, later investors by acquirers, early employees are sometimes replaced by seasoned executives as a business grows, and little products become big and complex as a business matures. The wheel perpetually turns, and there are always exits.

Which is all the more reason why understanding the mechanism of discounted cash flow valuation is important for the entrepreneur. Not only does the underlying financial model capture very precisely the math illustrated herein, but the method depends largely on what is known as terminal value. This is, in essence, the grand finale of exits… Except… Except, it really isn’t. The wheel perpetually turning, one investor’s end is another’s beginning. Terminal value in one model is the entry point in a future other, which future other will itself be built upon a terminal value that will mark the origin of another investment, two degrees of separation out. And so on.

Discounted cash flow valuation is not the only technique that works, but all the others in one way or another relate back to this one, from which there is no escaping. And in its functionality, the model demonstrates several broad tenets: In isolation, a product can only be a depleting asset, whereas a business should be an ongoing concern; in isolation, a business should have greater value tomorrow than it does today, or else it is a depleting asset; when building a business, ignoring the long term is like ignoring value, but when building a product the long term is less essential. When entrepreneurs build, it is important to understand what it is they’re building, and seek exits accordingly.

Back when we still talked about returns rather than exits, when we referred to capital instead of liquidity, entrepreneurship was defined as business-building. Somewhere along the way, the distinct notions of product and business got all tangled up in one another. At least financially, it would serve a noble cause to untangle. Entrepreneurship, you know, is not a recent invention, and venture capital was, as a class, more profitable once.

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Of seedlings and an anniversary

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Everything you can think of is true. It’s an infinite universe, and we are all, by definition, visionary. Nevertheless, this alone does not make our entrepreneurial venture valuable after the seed round is funded. If seed finance is about possibility, the round that follows is about proof. It’s about actuality. In short, about execution. And it isn’t that vision is less important, or less admirable, at that stage. But the stakes rise, the funding requirement grows; as does, presumably, the valuation. The core asset is no longer the optionality of a great idea and an inspired team, but the way in which this becomes a business: The option is exercised, and there is equity.

From first to second round, there is a world of difference, and those who haven’t experienced this difference will learn a great deal soon. It’s going to be soon, according to my calculations, because the surge in seed investing, that some haven’t called a bubble, will soon reach its first anniversary. I’m approximating, and we may already be there, depending on when you marked off your calendar last year. It’s possible that the surge even began as far back as Fall 2009, in which case we are now pushing up against 18 months. Regardless…

Here is where I’m going with this train of thought: Seed rounds usually suffice to finance a startup for a period of 12-18 months, give or take and depending on the startup. Speaking purely generically, and assuming that on a time-weighted basis the average seed capital recipient in the frothy class of 2010 secured its startup round mid-way into the year, this prototypical venture should be coming to market for its subsequent (and bigger) round of capital in the next few months. This deal, on average, should get closed by year-end. And while there is debate about a seed bubble, there isn’t much to suggest serial percolation into the later rounds. In short, we will start to hear the war stories.

A long time ago, seems like ages, I jotted down some thoughts about a looming exit bubble of 2012. This had more to do with a spike in private equity and venture capital fundraising that took place in the 2005-2007 period, and was predicated on a typical 5-7 year hold period for portfolio assets. Thus, a corresponding exit spike in 2012. The calculation was overly simplistic and rigid. It did not take overhang into account (i.e., capital that was raised but not actually invested), or the possibility of hold periods beyond 7 years, which isn’t at all unheard of. It was a back-of-the-envelope estimate, and I still stand by it as such. The recommended course at the time, which has not changed, was for fund managers to “beat the rush” and consider orderly exits well in advance of 2012 – though, I suppose, we are not well in advance any more.

The recommended course for entrepreneurs, who may be facing related issues as noted – perhaps even doubly related, as the venture community into which they will be marketing may be as interested in exits as in investments in the several years ahead – is to build businesses from the very origin with the next round in mind. This is to say, if one’s startup calls for additional capital beyond the seed round, and this is known early on, build to the follow-on raise from the outset. This, still again, is to say, build a business, an actual operation, professionally and with as much attention to management, systems, and execution as if the enterprise were already funded with its subsequent (more institutional) round, and start doing so as soon as the seed money arrives.

There are practical limitations to this recommendation, which I recognize. I also recognize that nimbleness is important for an early-stage venture. So what I am really trying to say, I suppose, is more along the following lines: Don’t fall in love with ideas – these are a flighty sort – but find romance, instead, in execution. This will last.

The time to raise your start-up round is when you think you’re ready.

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Contrasting styles of CEO: Google and the Fed and their signals

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Maybe a study has been conducted to measure the correlation between the time a CEO spends marketing to shareholders and the value of the company’s stock. I haven’t seen such a study, but am beginning to suspect an inverse relationship. Whether this is counterintuitive or makes perfect sense, whether a CEO should be busier working on results than describing prospects, this is all debatable. And anyway, the balance between the two will vary with circumstance. Based on my own unofficial survey, however, I see a pattern worth noting.

Here is Larry Page of Google fame, descending to the presence of shareholders for about three minutes, to read from a prepared statement before bailing out, at the company’s quarterly analyst call. In contrast, here is Fed Chairman Bernanke, who lately can’t stop mingling with the crowd for any extended period. After 60 Minutes, next there was an unprecedented press conference at which the head of the (normally) tight-lipped, highly controlled and choreographed central bank – each published word of which is scrutinized by economists for meaning, context, symbolism, pattern, inconsistency, and all manner of scholastic methods that border on the Talmudic – went on to explain and describe and justify and so on. We can reasonably assume he will not pause for breath soon.

Granted, there are extenuating circumstances to the Chair’s chattiness, such as for example the pre-approval requirement of questions from the press, a courtesy that he is unlikely to be shown otherwise, such as at, say, Congressional hearings. Nevertheless, Congressional hearings have been a constant for the Fed and its Chair, but it is precisely at this time that a press conference has been called, and it is precisely at this time that the U.S. dollar – the value of which falls squarely under the Fed’s purview to protect – has deteriorated like no other global currency. The equivalence between a currency standard and a corporate stock is in no way pure, but if you accept my poetic license and the contrasting styles of Google’s CEO and the Fed’s CEO in the face of respective constituencies, it does seem as though one of these executives is more comfortable than the other with the prospects of the asset he is managing, and feels it is less necessary to have to explain.

The contrast between execution and explanation – which, by the way, is in no way intended to diminish the communication aspect of the CEO’s job description (so, I should rather say, the proportion or disproportion of execution and explanation in the two examples depicted) – is reminiscent to some extent of the contrast between operators (principals) and investment bankers (agents). The latter are often hired by the former to tell the story, so that the former can stay focused on value creation. Sometimes, though, the value is the story, or vice versa, and that’s when the CEO may find him or herself on a continuous roadshow with the investment banker alongside. For very early-stage companies, the two roles are combined into one because, in fact, these are the projects where the story is pretty much all there is. These are the highest-risk investments, which I am pointing out not to state the obvious but in keeping with other analogies drawn herein.

So, when I see the Fed’s operating head take time away from his busy day-to-day to focus on investor relations, I can’t help but wonder if this has something to do with operations slowing down. In particular, I am thinking about QE2 and its approaching end. Time flies – it seems like only yesterday that the S&P and other asset-valuation indices began an ascent that has been difficult (almost impossible) to explain by pure business fundamentals – but the monthly liquidity added to capital markets by artificial means will soon have to come from more natural sources in order for the pattern to sustain itself. Unless there is a QE3, which there may yet be, perhaps the Fed’s job function must thus expand to sell-side investment banker?

Anyway, there is a great deal of speculation and imagination run wild in the above, which makes for one or two entertaining moments, if that, or at least to myself. In the next article, following up from here, I will try to show how Fed policy, the U.S. dollar, and Google, all come together t0 influence the existence of startups, venture capital and entrepreneurship in immediate and practical ways.

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A bubble of non-commitment

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Liquidity and bubbles are closely related. Liquidity, however, is not always financial; and bubbles, contrary to consensus, are sometimes based on fundamentals. Bear with me.

Awhile back I raised the possibility of technical as the new fundamental. The point was this: When a refinancing (or an exit, or a trade) rather than a repayment of an obligation is the primary source of investment return, a financial instrument is more dependent on market liquidity than the cash flow generated by its underlying asset. There is also a subordinate point: When a refinancing (or an exit, or a trade) rather than a repayment is the primary source of investment return, the investor’s decision is driven by near-term market flexibility rather than the long term operational prospects of the underlying asset.

Examples of these general observations used to be limited to public stocks, but since the ’70s and ’80s, and increasingly in the last decade, have come to include debt instruments of all kinds and all manner of derivatives of these and countless other securities. Most recently, venture capital – an asset class that had historically been noted for extreme illiquidity and extensive holding periods – has begun to trade on private secondary exchanges. With enhanced tradability – especially for select names, select enough to not warrant scrutiny and questions and requests for information (like financial statements) – return hurdles diminish, and valuations, accordingly, increase.

The scenario is not different, in a certain sense, from previously experienced bubbles that, too, were triggered by surging market liquidity. For example, take sub-prime mortgages: That market took off as a result of the packaging and securitization of assets in a way that led to more efficient trading, and the structural liquidity this created maximized capital flows into the system. By extension, issuers – in this case homeowners – were encouraged to be more active, to take greater risks (but in their case the asset, a house, remained illiquid), to deliver product so that capital could work. The bubble that grew as a result of each side leading each to greater heights was, in substantial ways, justified. The boom, as some would call it today, was based on liquidity fundamentals – even if it was a bubble.

These thoughts and others came to mind the other day, when at a time that the S&P/Case-Schiller index showed lasting and overwhelming devastation in that illiquid asset class – real estate – the public stock market surged to levels unseen since such devastation first occurred. The driver of the surge was attributed to consumer optimism, (although it’s hard to reconcile collapsing property values with positive vibe from the populus, no?). What if, instead, the pattern is an extension of themes experienced elsewhere: a rotation of funds out of illiquid and into liquid flows. What if, instead, the populus is shifting its attention from things that must be owned for very, very long, to positions that can be reversed at the click of a button?

Such a rotation to the liquid from the illiquid can also be detected, perhaps in a more abstract sense, in the case of entrepreneurship. This is the flip-side of the coin where venture capital (previously touched upon) resides, and here with greater acceptance and pervasiveness the notion of entrepreneurship is equated to what is, more correctly, serial entrepreneurship. This is to say, the goal of the effort is less commonly portrayed as one of building something of lasting value, or an enterprise with which to grow old and retire, but to build something for which to raise venture funding, or an enterprise from which to exit. The analogy of refinancing a home, or buying a second and third with no money down, is not far off. Neither is the idea of stock trading, or maybe it’s mainly a difference in nuance, or a matter of degree. The entrepreneur, in this way of thinking, is more a marketer than an underwriter, in keeping with the Wall Street motif presented.

Which is understandable, as suggested. Liquidity, flexibility, and diminished risk of long-term ownership, are not objectives for which to fault anyone, and certainly not in the volatile mixture that is the global economy in general, or technology in particular. On the other hand, however, bubbles that pop – even when built on justifiable foundations – do so because they have gone to excess. Maybe there is a point at which nimbleness goes too far. Follow-through – requiring long-term commitment – is what forms value. Rapid ideas, fits and starts, drive churn.

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Investment and consumerism in parallel

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The argument is moving in a new direction for the subject, and it’s an angle usually reserved as last resort in debates that have otherwise abused all angles and gone nowhere: Semantics. For example, we are not witnessing a “bubble” but something new: a blubble. The meaning of this new word is intentionally vague, though it appears to be along the lines of “not-bubble,” only with a name. Alternatively, the not-bubble has been referred to as a boom: a more legitimate approach to naming the not-bubble – using a legitimate word – but for the same reason flawed. A “boom” implies an underlying surge, a revolution, a fundamental explosion – like, for example, railroads and computing – that cause industry to permanently change. While the Internet surely qualifies, it wasn’t in the past year per se that such disruption most substantially occurred… at least not such as would explain investments seen again and again in this great blubble.

If anything, the major changes of the past year have been financial in nature: the widespread emergence of dedicated seed-stage investors on one hand, and secondary private trade on the other. In both cases, the phenomenon has bred a surge in liquidity for investments – not unlike, and in fact running parallel with, asset inflation caused by quantitative easing – represented by more numerous sources of capital for the high-risk startup segment at one extreme, and marquee brand value at the other. In both cases, if there has been any such thing as a frenzy, it has been a rush to put money to work and, the close corollary thereto, a fear of missing out.

If some want to think of this as a blubble, alright; if others want to call it a boom, maybe not so much; and if still others see it as herd activity, maybe that’s closer to the mark; but what the environment seems increasingly analogous with, in its manifestation of perennial behavior in a new (post-QE) guise, is consumerism. More particularly, maybe we are noticing in the tech bubble (or not-bubble) the same must-have attitude that has permeated discretionary (non-essential) spending for decades, causing it to expand almost parabolically since. When lines stretch around blocks outside the Apple store on days of a marginally new product introduction, is that particularly different from a widely syndicated seed investment in the umpteenth photo-sharing app? And is this far off the mark in relation to the purchase of Facebook shares at surging prices, without having seen a financial statement?

One aspect of consumer trends that seems always to remain, is that tastes change and frenzies pass. One way we will find out – or perhaps already have – whether the described investing landscape is as solid as a boom or as fickle as a bubble, is to watch for stubbornness in investing themes and convictions that don’t travel in cliques. Good investments, based on thoughtful analysis and long-term perspectives, happen individually all the time. Whether the same holds true for an asset class as a whole, or for an era defined by its moods and manners, is what differentiates opportunity from fashion, and value creation from popular consumption.

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An entrepreneur’s guide to the trading desk

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Earnings season is always an exciting time to watch markets, even if only for entertainment value. Financial gamesmanship seems always to escalate, or at least manifest itself more visibly, when companies announce their quarterly results. There is not only the bilateral dynamic between guidance and actual postings – a delicate balance – but the triangular relationship between guidance and results and market expectations. The market, after all, makes its own assumptions and has three months between seasons to fine tune and adjust. In regard to expectations, furthermore, there is the interplay between analyst consensus and whisper number, and all this before we even get into systemic factors that push values up or down regardless of a company’s performance.

Entertainment value aside, interpreting (or at least monitoring) these gyrations, convolutions, relationships and inconsistencies in the public markets, can be important for those outside of the daily trade. For starters, there is an inherent statement in the markets about the broader economic environment and its prospects. The cause and effect of markets and the economy, and vice versa, is not always straightforward, especially not since QE2 was launched to inflate asset values and create a “virtuous circle” that would lead to jobs and consumer spending and higher prices. Even so, a close look at these and other variables is worth the effort because the most disinterested stock picker is nonetheless bound by basic economics.

Another reason to monitor the flow is to glean insights this provides into the funding market, for which the public environment often serves as a guide. It isn’t only that private valuations are informed by public metrics, but that the very consummation of private transactions is influenced by the health of public holdings and assets represented thereby. When, back in 2008 and 2009, public stocks had fallen, M&A as well as private investing came to a relative halt. For strategic buyers this had a lot to do with loss of confidence, which relates back to economic aspects described in the earlier paragraph. For financial investors, this was the result of collapsing portfolio values, the math of which improved considerably in ensuing periods.

Among founders and other entrepreneurs, the topics raised are not common in discussions, focused as business builders rightly should be on building businesses. These subjects, however, and business-building are closely connected, and should take up a greater share of entrepreneurial thinking. Operations, growth strategies, product launches, customer interaction, and others aspects of successful enterprise being determined by economic conditions, and all such aspects requiring planning prior to implementation, economic advance notice should be much appreciated. The earlier and more complete the notice, the more effective the plan and its implementation. Although markets are fickle and sometimes anticipate but otherwise trail economic (and industry) patterns, thoughtful reading of market conditions will only complete a picture that couldn’t ever be too detailed.

As importantly, there is the aspect of corporate finance. Some businesses are never done raising capital, some investors are never done selling shares, and certain securities can never be done getting rolled over. Even limiting our discussion to the primary private market, certain correspondences stand out. For example, public stocks began their never-ending rebound from the depths of panic right around the time that massive liquidity through quantitative easing was introduced, and introduced some more, and is still happening. This parallel path has also coincided with the advent of what some now refer to as a seed and late-stage venture bubble. As argued in a previous column here, it is not only the bubble per se but the unevenness of it that can profoundly impact business ventures as these expand.

One starting a business, or one continuing to build an enterprise, should pay close attention to these issues, as these will determine the future to at least the same extent as the quality of a given product or a business model. While it is critical to think in terms of sector trends and venture capital motifs, for obvious reasons, it is as important to become versed in the esoteric: Inflation and deflation, quantitative easing and its impact, employment growth and ways that this is measured, the flows that push financial markets daily, and those that could cause directions to reverse.

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Incomplete, almost correct, miscalculations

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There have been interesting debates in the technology press of late. Decisions may be made, or unmade, on the basis of issues raised, as these discussions have covered spectacular subjects and lent themselves to momentous, nearly operatic, undertakings. For example, there is for investors the subject of a major bubble, or a minor not-bubble, or a hard to pin down sometimes-bubble, any of which possibilities is ripe with consequence. For entrepreneurs, there is the issue of the “pivot” – much less an argument per se than a mantra of sorts, and one that has become almost a badge of honor. Finally, for many blog readers a new subject has emerged, more sensitive than the others even, dealing with the issue of education. In these big themes, however, a small flaw permeates, having to do with definition and context. Decision makers, and un-makers, should practice caution as they embark upon monumental choices, because roads are slippery when approached with faulty gear.

Take, for example, the case of the alleged tech bubble. A frequent argument in defense of its non-existence is a comparison to the scenario of 1999 and 2000, at which time valuation multiples for public companies were truly spectacular and would in many cases make current standards seem timid in contrast. This is true enough, but by the same token the comparison is of apples and oranges, as it were, because of differences in context. Industry growth prospects when the Internet was at its literal beginning were far different from industry growth prospects more than ten years later. This is not a judgment call but a statement. And that only some investors are now participating in the wave, and that the wave is selective rather than sweeping across all variants, is also true… but does not diminish the possibility of wild overvaluation occurring where and when it does. An asset, in fact, can be priced low and still be in a bubble if its fundamental value is nil.

In regard to the “pivot” – that oft-used term which can only truly catch on like it has, let’s be honest, in an environment that tends to the bubbly – the misunderstanding ranges from mild to considerable. I mean, changing course in business is really a natural progression. When IBM morphed from typewriters to mainframes, was that a “pivot”? When Apple introduced the iPod after years of successful Mac production, was that a “pivot”? Why should natural evolution in an industry that is rapidly evolving get branded with a word that makes the process anxiety-making, self-important, and drastic? As though a wild adventure were in the making when in fact the enterprise is merely moving on… No big congratulations are in order, no trembling emotion, palpitations, ribbon cutting ceremony, because change is necessary to survive – like breathing, for example, the act of which does not elicit accolades.

Which brings us to Thiel’s education critique. The point made by the investor who correctly called both of the last two bubbles is that education has become bubble number three. Because the price of education and its value are far apart for many of the educated on grounds of financial calculation, this difference constitutes a bubble according to standard definition. Can education, however, be appraised like a financial asset? And even if it could, at what point after graduation is this value established? At what point after graduation does schooling actually stop? And what is the rate to use in discounting these numbers to present value? When treating education as a financial asset that can exist in a bubble in the same way that a dot-com stock or a subprime mortgage can, there is a definitional flaw and a distortion of context that serve to diminish the argument.

What all these examples have in common, more than the imperfection of each case as presented, is an insistence on rigidity and generalization, forcing simplistically derived rules upon highly complex and nuanced subjects. As such, guidance is offered up with almost aggressive confidence, and patterns of behavior are encouraged on the foundation of half-baked misconceptions. Mischaracterizing a financial environment is as perilous to the investor as aggrandizing the “pivot” is to the entrepreneur. At once exaggerated and insignificant, such arguments can lead to inaction or otherwise excessive expectation from an outcome. Education, among its other advantages, offers a defense against such risks.

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Investors in a portfolio of one

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Investing and entrepreneurship are two sides of the same coin, at least from the entrepreneur’s side of it. According to one definition of the word entrepreneur, this is a person who “has possession of a new enterprise, venture or idea and is accountable for the inherent risks and the outcome.” Note the presence of terms such as venture and risk in the definition. Note the root derivation from enterprise and its possession. These are words that could just as well be found in descriptions of investing and its aspects. There is, however, a difference of diversification, in that an entrepreneur will invest at any one time in a portfolio of one, and is thus accountable for its fate. Investors, in the pure sense, will spread their bets more liberally, and are by the same token less accountable. Oh well.

In the dance between the two – the ritual of raising capital to fund enterprise building – the entrepreneur nevertheless takes the investor’s lead. I say “nevertheless” because it should not be so, because according to the definitional analysis above, the risk and responsibility weighs much more heavily with the entrepreneur, for which reason alone he or she should be the more determined party. Nevertheless… entrepreneurs need capital and investors have it… so it goes. And thus, again, the way investors go so do entrepreneurs, most often. The theme is particularly pronounced in segments in which investor capital is the only capital, at least for a while, as revenues (let alone cash flows) are prone to lie somewhere along the proverbial horizon – which dreamscape may be more distant in certain ventures than others.

In following the lead of investors, however, entrepreneurs expose themselves to even greater risk than their singular non-diversification already creates. As capital providers are, contrariwise, diversified and risk-mitigated, they are also more careless because they can afford to be. For the singularly committed party to pursue a course laid out by the promiscuous is surely not a direction the former would willingly undertake, especially as the latter – as a class – has been known to travel in herds that are often flighty and blow bubbles that often pop. (It’s crazy, really, when one stops to consider, and downright infuriating when investors seek to convince entrepreneurs that bubbles don’t exist and not to worry about it so much, little feller.) But, as already stated, these things can’t be helped, so it goes, oh well, and all that.

Nevertheless… As one qualifies the distinction between an entrepreneur and an investor by defining the entrepreneur as a wholly un-diversified investor who must often follow the lead of others who have much less at risk but sometimes take condescending liberties from their position of strength, it may serve some entrepreneurs well to guard against recklessness in the following ways: Do not forget the importance of business fundamentals, as these defy herds and bubbles and outlast the same; if offered a choice, take your advice (and capital) from those with the narrowest diversification – as manifest in specialized sector focus and few offsetting bets; and remember that money is fungible, ideas come and go, but execution reigns supreme and thoughtful planning is priceless.

You may find, maybe not surprisingly, that this recipe leads directly to your customers. By far, these are your best advisors and capital providers.

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Entrepreneurs inside uneven bubbles

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As the tech bubble debate raged in the past weeks, I noted that the exchange did not include entrepreneurs as much as their investors. I was thinking to myself, as I was perusing the jeers, that the entrepreneur’s perspective should be central to the dialogue. I could understand why passions would flare for financing types, such being the history of bubble discourse in other market segments, where there is precedent. Nevertheless, there is a distinction in the debate at hand, in that we are mainly talking about the issuance of startup capital, the trade of high-profile secondary shares notwithstanding. The issuing entrepreneur is a party of interest, to say the least, and there are consequences.

For example, at its most elemental level, a startup financing that is overvalued (or overfunded) can lead to problems in subsequent rounds, even if many of these troubles are reduced by convertible debt structures that are fashionable today. Even then, the notion of issuing convertible debt is in itself emblematic of potential inflexibility down the road, not unlike the inflexibility brought upon owners of common stock when any senior-ranking securities are laid on top in the capital structure. It’s easy for founders to forget that preferred equity – especially with liquidation preference – is thematically a form of debt, which is to say, financial leverage, but hopefully the issuers of convertible debt won’t fail to notice this subtlety. And the use of any leverage in support of a highly volatile asset – such as an early-stage enterprise – contains inherent risk for the issuer (as described previously here).

Nonetheless, these issues and others are surmountable for startup founders in an environment in which the next round in line is perpetually more valuable. From Seed to Series A to Series B and C and whatever else there is until a successful exit, this is a long line of senior tiers and preferences that works out well for all involved as long as the line keeps moving. Whether the line keeps moving, though, is not a matter that the founding principals – who reside all the way down at the bottom-most capital rung – can perfectly control. Even with solid operating performance much depends on availability of follow-on capital, and market terms at which such capital is available: In short, there is the issue of market conditions. When, as a class, venture capital has generated flat-to-negative long term returns, the risk is material that market conditions will – just like that – show up in the guise of lesser liquidity in this segment.

To add an element of actuality to these otherwise conceptual ramblings, we can look at the current market environment in which – whether one thinks of it as a bubble or more correctly a herd – the movement is bifurcated towards seed finance on one side and late-stage secondary trade on the other. In this environment, for an entrepreneur to make the leap from the success of seed finance to the success of big-name trade, (which maybe does happen occasionally), does little if anything to address the need of the vast majority to raise several rounds of finance in between, where there is no bubble… and not even a herd. In fact, the universe of venture funds – those entities able to finance Series A and B and the like – has been shrinking, despite the growth of mega-funds (which probably feeds on the later-stage secondary bubble, as noted).

With due respect, therefore, to those who claim that the only group likely to suffer from the existence of a startup bubble is investors who can absorb the potential hit, I would add a second group to the mix: the entrepreneurs… especially those who raised seed finance (too) easily and were not, perhaps, adequately prepped for challenges ahead. And unless seed-stage investors can guarantee that, as long as a startup holds its end of the bargain with solid operating performance, there will be follow-on capital available at attractive terms, I suggest that encouraging entrepreneurs to disregard the possibility of a bubble is the wrong thing to do. When an investor argues the case to an issuer that his or her business valuation is not excessive – far from it! – this is at least on the surface counter to nature, to market mechanics, to age-old negotiating standards, and one side or the other (maybe both) should pause in the conversation, and reflect. A disservice could be in the making.

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