PureVC

Quantitative Metrics in Your Business

There have been various follow up questions to my posts on making a Due Diligence Binder and making business plans in general. In an attempt to help out entrepreneurs who continue to send me business plans and put in my two cents about what I like to see at monthly or quarterly business meetings, here are my thoughts on the matter.

Far too often I see a plan that is heavy on "mission" but very thin on "metrics." In my opinion, a good business plan will have both a micro and macro analysis. Most business plans have lofty projections of revenue and profits. What they don't always have is a clear outline of the important metrics relevant to your business. This is a basic concept that is far too often overlooked.

In a sales business, it is obvious that product sales are the main metric. In a food business it is probably meals served. In a laundry business it is turns per machine. Whatever your business is, clearly define what metrics are relevant to measure and gauge the growth and trajectory of your business.

I like to call that "macro" analysis within a business or business plan. What I refer to "micro" analysis is an analysis of the business and its margin on a dollar basis. I think it is a very elegant thing when a business plan contains a simple diagram that shows $1.00 of revenue and how that dollar is split between various expenses and profits. I quite honestly only see this type of thing from business plans from serial entrepreneurs. It's surprising because typically a sophisticated entrepreneur will come up with profit margins and excel spreadsheets showing these margins based on business projections. It is nice if you can simplify this down to a single dollar analysis. f you can show me where that $1.00 goes, I can see clearly what the margin is like and how much of that goes to the bottom line.

When it comes to updating your Advisory Board, please define your goals and objectives in relation to those metrics. While it may seem elementary, I support the use of basic Goals & Objectives formats or some variation thereof. When I go to an Advisory Board meeting, I expect the package and update to contain a set of previous Goals of the business overall the last quarter and future quarters. The specific objectives need to be revisited to see if they were achieved. If they were or were not, some time should be spent on an analysis of the success or failure.

I feel that time in an Advisory meeting should be spent first reviewing progress on the G & O. Then time should be spent on strategizing how to improve on both the "macro" and "micro" metrics. Thus, time should be spent on how to grow the business and on grow the margins.

In this day and age of snazzy and jazzy business plans, it is important to keep these basic thoughts in mind. Investors and Advisors want a transparent and simple way to gauge the health of a business. If you cloud it with smoke and mirrors you'll only be doing yourself a disservice.

The Federal Government is Your VC

Today is tax day and it has been a hectic few weeks for me. I typically file my returns on time and then file an amendment in July or August when my final K-1s arrive for all of my limited partner interests. One of the frustrating things for many PE investors is that your taxes must always either be filed and amended or extended for one filing. If you think about all of the various levels or return requirements for different funds, you can imagine why an LP gets its tax information late. All of the portfolio companies must have their valuations complete in order for the fund to be able to get is return complete. If the fund is a seeder fund, you can imagine that it will take time for every underlying seeded fund to get its return.

At any rate, one thing taxes always remind me of is how accountable we are to the Federal Government. We scurry around and stress out and pay good money to get our taxes filed. In essence, we must report to the IRS, much in the same way a portfolio company reports to its VC.

It does seem that essentially the Federal Government is Our Venture Capital Investor. They own equity in each of its taxpaying citizens. The better we do, the more revenue share it gets. If we found another company or hit it big winning the lottery, the IRS gets its cut. The only real difference is that a VC will usually only get its take during a liquidity event, while the IRS wants it in quarterly payments and on tax day.

Perhaps, that makes the IRS somewhat like a buyout firm that extracts our cashflow. In that case, it's a vulturous firm because it extracts so much cash flow that obviously hinders our ability to gain more profits. We all know that if we had that extra money that went out the expense column as taxes, we could invest more and utilize it to make even more money.

If you are interested in how a PE firm ideally wants to take control of its companies and reap profits from them, just take a look at the Federal Government. They have it down to an exact science, including a loophole called the alternative minimum tax to ensure that people pay a minimum amount of tax despite the use of many legal deductions. I guess it is the one time where a public entity may rival private industry, the IRS vs Private Equity firms, which do you think is better at collecting money from its investments?

Vonage Troubles - Some Lessons Learned

There is a reason why I don't usually buy into IPOs and the events at Vonage since its IPO illustrate why. When I posted on the IPO, I mentioned that it was a lofty valuation. I'm not here to say "I told you so". In fact, several funds which have some of my personal money have had exposure to Vonage. Most of the funds made good money on the IPO, but those that held certainly could have made more.

Since its IPO, things haven't gone well. The first problem they encountered was from their own subcribers who had the option to purchase the IPO. When the thing tanked, those were the first people to get upset and want their money back. This provides a good lesson - if you are a consumer-based company that relies on subscribers, don't sell your IPO to them. If they don't like the IPO or the service, they will dump both of them. Google didn't heed my advice and they didn't have any problems, but then again, I would not consider them a subscription-based service.

The second problem they had was that they did not have good IP protection on the core of their model. I guess to be fair it is difficult to presume that any VOIP company would have this protected. But the truth of the matter is that because they lost their lawsuit to Verizon and have more lawsuits pending, it really puts their model at risk. In some sense, they are a victim of their own creation. By being the first out of gates with a service that many would argue uses the bandwidth of other providers, Vonage was an easy target. So the lesson here is that it is a good idea to make friends with the big industry players before you try and make a move on them. YouTube did not do this but they were lucky enough to be bought by smart people at Google who immediately reached out to the video & tv industry to try and sort out content IP issues.

Another issue with the company is that they laid out too aggressive of a growth plan. Recently the company admitted that its television advertising campaign simply is not attracting enough users for the cost of it. I do like the tune of their commercials, but I'm still not a Vonage user today. At any rate, the company recently announced that the founder and former CEO, Jeff Citron is taking back the helm of the company. Mr. Citron has had his own issues from his days back at Datek, although I have forgiven him for whatever he did at Datek because I still believe hands down that they were the best online broker and were responsible for transforming the securities industry through their Island ECN.

It will be interesting to see what Citron does from here. Investors are pissed. The stock is in the toilet. And there are lawsuits with some major industry players that are not resolved. Do you think they would have been better off staying private?

Where Would You Invest In Private Equity?

Poll results are back for Our First Poll here at the PureVC blog.  73% of responders indicated that they would not invest in the Blackstone IPO. I was among the nays of the group.

I'm not sure what it means, but it clearly shows that readers of this blog can taste the frothiness of PE firm valuations. It will be interesting to see how this closely followed IPO turns out. The rumor mill has been churning these last few weeks of an Apollo Management and a KKR filing. I can't wait to get my hands on the filings and see what has been behind those closed doors.

So now it is time for our second poll. In an effort to stimulate some thought and in light of all of the emails I have received about the different types of private equity, this week's poll wants to know if you had to choose one category of private equity in which to invest, which would it be: Venture Capital, Buyout Funds, Hedge Funds, or Real Estate?

Once again, the poll password is purevc

Compensation Structures at PE Firms

I am weighing an opportunity to join a unique PE opportunity as a Principal/VP.
Can you share with me how compensation at that level is structured?

This is a difficult question to answer because internal firm structures vary considerably. A common structure is a partnership structure used at VC firms. An alternative is more of a corporate structure. At any firm, whether it be a PE firm or a Law firm, there is always going to be an Inner Circle of Founders and Partners.

Given the evolution of Private Equity, it is clear that the partnership structure is more old school and the "institutionalization" of firms has brought about a corporate ladder. I have always felt that one of the weaknesses of the partnership system is that it is nearly impossible to break into the Inner Circle. Either you have to climb the ladder for too long or you need to hit a huge winner. Either way, this obstacle is the primary reason that firms have trouble retaining their stars. Either they let them join the Inner Circle or they will end up being your competition. Not that I want to mention Blackstone again, but their $40 billion valuation would beat Lehman Brothers $39.5 current value (both Blackstone founders were previously at Lehman).

Even though this reader's question is about compensation at the Principal/VP level, I am mentioning the Inner Circle because the objective of anybody at at PE firm should be to learn the skills necessary to run the show. It simply isn't in the personalities of most young ambitious financiers to one day become the second or third guy in charge. Those that are second or third are likely to be patiently waiting the changing of the guard. Otherwise, those guys are the type that probably never imagined being there in the first place and are more than satisfied with their wealth and their extracurricular activities.

One other difficulty in talking about compensation is that nowadays firms have so many levels within their ranks that it is difficult to gauge who actually does what. I would say the more common spectrum is this (with some having multiple levels):

Analyst
Associate
VP
Principal
Director
Managing Director
Partner

The main difference between firms is how much carry is shared with the lower tiers and how many levels of lower tiers there are. At many firms, you will not share in the carry until you are a Director. At some firms, you will at the VP or Principal level. At some you will at the Associate level. It is rare to see a piece of the pie given at the Analyst level.

What is confusing is that duties for a given title vary among firms. This also depends on firm size and number of employees. I don't think that the Analyst/Associate duties have changed much, but in between that level and the Inner Circle, things tend to blur a bit.  To make matters worse, some have titles that aren't widely used, such as Capital Raising Specialist. 

I would say that at the Principal/VP level compensation ranges from 200k to 400k with half or equal as a bonus and a carry that can be up to 10 times that amount. I don't have any statistics or hard data to support that and given the PE boom these last few years those numbers could be way off. As you can see, what is important is the carry.

You need to take what I am saying with a grain of salt. Compensation will vary according to fund assets under management, years of work experience, contribution to successful deals, graduate degrees, and other things that are out of your control.

The CXO Network

I've been running this blog for a few years and every week and month my readership has been increasing. I'm getting more emails from entrepreneurs, investment managers, students, and curious people than ever before. Some people respond to specific posts, some people have specific questions they want answered, some people are pitching their businesses, and others are looking for funds or advice. I welcome all of this communication and will try to get back to you as soon as possible, following my own set of Business Etiquette rules.

At CXO Ventures and CXO Private Equity, we have always had a relatively closed network of investors, entrepreneurs, investment managers, and advisors. We tend to do business with people we know or people who know someone that we know well. It's not because we don't trust people or because we don't do due diligence. We have found (and others have too), that investing in successful people or people you have worked with before (and thus know very well) has a higher likelihood of success. In addition to feeling more comfortable working with people within our network, we feel we are better serving our investors and adhering to our fiduciary duty to manage their financial interests. In some areas of Private Equity such as Real Estate and Leveraged Buyouts, we feel it is essential to know the developer or the management. In other areas such as Venture Capital or Hedge Funds it is important but less realistic to have every deal done within our network.

This blog has generated a lot of interest in our firm. We have found that the readers of this blog tend to be a select group of people. If you have found this blog, you have found it by word of mouth, by reading someone else who links to us, or by searching for a specific topic on Google and wading through those results to find us.  We have been close to doing business with several people who have come to us through this blog. In fact, there are definitely readers with whom I ping regularly on several topics.

In an effort to formally expand our network and to perhaps better serve you readers, I am extending a formal invitation to readers who want to be added to our network list - entrepreneurs, investment managers, investors, students, and anybody else. Here are some details of each list:

Entrepreneurs - Network of entrepreneurs in our network that we would typically contact if there is an opportunity within one of our companies or if we have an idea we are willing to fund and are looking for someone to run with it. If we know an investor that may be interested in finding someone with a particular background, we will pass the entrepreneur's information on to them.

Investment Managers - Network of managers that are looking for deals in a specified category of Private Equity. We refer deals that come to us that fit the profiles of our managers.

Investors - Investors with an appetite for a specific type of deal or category. We see a lot of deals that we pass on. We can direct you to these deals or to people we know to help find what you are looking for.

Students/Interns - Although we do not offer an internship yet, we maintain a list of interested persons that we may have unique opportunities for in the future.

If you have an interest to be added to any of these networks, please contact me with your information (email, phone, address) and a little blurb about yourself and what you are looking for. We are sparing in our use of our network lists and typically we send out notes to people who confirm that they wish to continue receiving our contact. I hope this is ultimately of benefit to both of us. I am hopeful it will increase the efficiency of our deal and job matchmaking.

Please note the following: This is not a solicitation for investment. We do not solicit investors. We do not share information outside of our firm. We are protective of proprietary deal information. We will seek permission for information sharing for each specific transmission.

Private Equity Returns

Last week I received a note from a reader who wanted to hear my thoughts on this table of private equity returns from Thomson Financial/NVCA (Download pe_industry_performance.xls). In specific he was wondering why the 1 year returns of buyout funds are significantly higher than in subsequent years.

I think the table of returns is interesting. I do not know the specific inclusion and exclusion criteria of the data. However, I am surprised that the 5 yr and 10 yr returns of buyout funds is not higher. This is somewhat suspicious to me. I am also suspicious of the table because if you look at the VC returns of 1 and 3 years, across all stages, they seem a little high to me. Most of us know that vintage 2000 to 2003 have not had strong returns.

At any rate, what I will first say is that you must take these tables with a grain of salt because this is PRIVATE equity. It is difficult to get data from every partnership and every transaction. Additionally, given the J curve effect of funds, not all funds can be compared, nor can you compare funds at different stages of their life cycle. The only way to really get accurate data on a fund is when the fund life is over and the fund is completely liquidated.

I'm not trying to avoid the question or evade the truth behind returns. But a buyout fund will invest in a company and ultimately have a liquidity event. Just because it has a liquidity event doesn't mean that it has realized all of its gain. So when you hear that KKR or Carlyle or Blackstone has flipped their investment, the truth is most likely that on paper they have had a huge mark up in value, but they probably have not liquidated that investment. Hence the return on that fund may be only the realized return and not inclusive of the unrealized return. Given the variance and leeway in valuation practices by accounting firms (many funds value their investments at cost, irrespective of true value), you can imagine that the only way to figure out the return is by counting it up when all is said and done.

OK, now to the real question. The 1 year returns are probably higher than other periods because the last few years have provided more liquidity to buyout funds than previous years. The new issues market has been slow and the markets have shown an appetite to buyout-backed new issues. So there has been more liquidity for buyouts. Given that most of these issues have done well in the aftermarket, it is imagineable that the 1 year returns are higher because of more activity in the new issues market.

Similarly, buyout funds have ballooned in size and have done club deals and thus the secondary buyout is more common. Instead of holding that company for 4 or 5 years, funds have been able to unload earlier to other bigger funds in secondary buyouts.

Money has also been cheaper the last few years. Thus, funds have been able to do more deals with cheaper debt service.

Perhaps an additional factor is that there have been more quick flips. I'm not sure if this is true. Although the quick flip clearly has garnered more publicity than in the past.

It would be difficult to prove any of this. We all know that fundraising is at an all time high and that deal size is getting bigger and bigger. I'm sure someone with more time than me could come up with numbers showing that total buyout activity has increased over these period as well.

Big (Potentially) Changes in Private Equity Compensation

Rumors have been floating the past few days that legislators are mulling a change in the way management fees and carried interest will be treated for tax purposes. The Deal, Wall Street Journal, and PE Hub all have blurbs on this rumor. Dan Primack has once again posted a nice document dump that has an alert to private equity clients from a law firm.

For those of you that don't know about management fees by private equity funds, read some of the old posts from my VC Primer series on Management Fees and The Carry. What the issue comes down to is that annual management fees are taxed as income on investment managers at high rates (30% to 40%). The carry, or incentive allocation from a fund's winners, are taxed as capital gains at low rates (15%). This is because the carry is considered "deferred compensation" and results from the capital gain on invested funds.

Legislators have been considering changing the carry from a capital gain to earned income. You could imagine the potential havoc this would wreak on the private equity community. Essentially, private equity managers would be getting a 20% haircut on their carried interest profits!

One reason the issue has come under the microscope is that as funds have become larger and larger, management fees have ballooned. Investment managers have found an innovative way to convert this immediate income into deferred compensation. Typically investment managers contribute a certain percentage of a fund's size, typically 2% at the low end. Instead of contributing this money upfront, managers have been opting to get paid their management fee in the form of equity - basically instead of putting up 2% they have used what would be their management fee as their capital contribution. What this effectively does is convert what would be taxed as income (management fee) into equity that they would otherwise contribute and that down the road will earn them deferred compensation (carry). While this might seem like a tax loophole, it is a compensation form that is commonly used in any startup. Founders and managers always to some degree earn equity for their efforts. In the pooled investment arena, "sweat equity" is not a new concept.

What is disturbing about this is the clear lack of understanding legislators have on this matter. While some may consider the fees and carry charged by PE managers ridiculous, they have always been this way and are a huge incentive for mangers to earn outsized gains. Taking away private equity's "sweat equity" that comes in the form of the carry is like taking away a founder's stock. We all know what would happen if founder's stock was taxed as earned income and not as capital gain. If things are moving in this direction, why have a capital gain tax at all and just treat all income as earned income?

The economic machine of this country has always run on risk investment capital with generous tax incentives. Whether it be venture capital, hedge funds, or leveraged buyouts - private equity funds are all drivers of economic efficiency. As long as people use the best products, money flows to the highest return, and investments are made to transform companies for better return, then private equity has done its job on the economic forefront. I am not even considering the impact of job creation and new industry creation. Peaks and valleys of the markets are necessary to wash away inefficiency. Private equity just like other economic factors plays a role in this.

By clamping down on private equity, legislators could potentially turn off the engine of innovation and some large drivers of economic efficiency. I'm not really sure this will ever happen, but if you've been around the lately you've seen legislators single handedly shut down the US new issues markets and make foreign IPO markets large world contenders in a matter of a few years.

I'm sure the best and brightest in private equity will continue to find ways to combat this. Perhaps by the sheer dollars behind their lobby. Perhaps they will find a way to convert their compensation in the form of equity in underlying companies. Perhaps derivatives or contracts will be used between funds and their managers. I'm not sure exactly how it will pan out, but if these changes come, legislators will have thrown down the gauntlet on PE managers. Let's hope they are ready to play ball.

How many founders do you need for a startup?

Brad has posted today about the topic of founders and how many are needed for a startup. Interestingly, there is a table showing some famous startups and the number of founders. Apparently, two founders seems about average. I personally don't believe there is a magic number. There must be enough of a core nucleus to sustain the vision if someone decides to bail. There must be few enough so that the founding group does not get bogged down by size. The reason I think the topic is interesting is not because there is a "good" number of founders, but more because it touches on the topic of founder ownership.

In working with entrepreneurs, I think there is an obsessive concern with dilution among founders of a startup. Too often I find that when people form a startup they are very weary of sharing the idea with others or bringing others on board. All they want is the funding - they fear that taking on additional founders or employees during the formative stages will dilute their equity.

My response is always that if you are worried about equity, then being greedy is going to be what prevents your equity from being worth anything. Do you want to own 100% of something worthless? or 25% of something extremely valuable?

Sometimes it is better to bring in more people to have more energy, enthusiasm, and ideas. If you are obsessed with equity and people jumping ship prematurely, then feel free to make clauses that allow buyback of founder's stock if they leave within a certain period of time. Feel free to have noncompete clauses. Do whatever you need to do to allay those fears that other people will dilute your ownership. Think of the founding group as being the core nucleus of the operation. You want a strong group with a similar vision. You want individuals that complement each other. You don't want people overextending themselves and doing too much. You don't want people who will clash. You want everyone bringing something to the table.

Let me once again say that the most valuable thing in a startup should be its equity - do whatever you can to increase this value, even if it means giving some away to bring in talent. By seeing this big picture your entrepreneurial experience will be more rewarding and you will be able to share this success with those early founders - these relationships will be something that you will cherish and that you will likely continue to enjoy as you start your next endeavor.

Money Is Not Free

There are a lot of great people out there looking for funding. They have a great idea and have put together a business plan. Perhaps they have talked with some venture firms or some angel groups. While they are not completely sure about their business plan or strategy, there is one thing they are sure about - they want (need) funding to give their idea a go.

What is the best way to raise seed capital? I get this question a lot. Quite some time ago, I previously posted "Should You Take Venture Capital?" about some points of consideration for taking venture capital. If you are still certain that you want to raise money, here is one thing you need to know - MONEY IS NOT FREE.

I know this sounds obvious but it is clear to me than many entrepreneurs don't understand the many expectations that come with receiving funding. By laws of economics (or perhaps greed), at any point in time, money tends to find its way to places that have the highest return. Call this economic efficiency, call this maximization of potential, whatever you want to call it, if money comes to your company in the form of seed or venture funding, it is coming to you for a reason. It wants to be multiplied many times over and your company is the vehicle to allow it to do so. If you are lucky to be working with a classic venture investor who sees beyond return and wants to create something with technological, social, or cultural value, then you are one of the lucky few. But on the whole, if you get money from an angel or venture firm, know that they are expecting large returns.

What does this mean for you the entrepreneur? Well for one thing, it means that you need to know your investor's expectations. If you know your funding source is looking for returns, then you need to plan and show a trajectory that leads to this. Too often, I see people that just WANT THE MONEY IN THE BANK! They have no clue that once they have money in the bank they will also have someone that is up their XXX every day, week, or month. They have no clue that in 6 months to a year the money will run out and their world will crumble all around them if they don't find more money. They don't know that they will have lost that time earning wages, have probably lost some significant personal funds that they invested, and that they will have potentially ruined their reputation as an entrepreneur if they do not handle things responsibly.

Don't get me wrong, I am a huge advocate of angel and venture funding. I believe in it and believe entrepreneurs benefit from funding. However, I really feel that many entrepreneurs do not understand that taking funding is a serious thing. Are you ready to be the steward of someone else's money? Are you ready to report on the progress of their investment on a daily or weekly basis?

Remember - Money Is Not Free!