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August, 2007:

Bubble Factors: Real Change, Easy Credit, and Self-Interested Lies

Look at “Bubble 1.0” (as it’s known in the relatively young tech industry: the 1997-2000 tech-media-telecom bubble and the general IPO / equity bubble that went along with it).

1. A real change occurred — the uptake of Internet technology — and created some initial successes (think Netscape IPO). This got folks thinking about how to turn a profit, lighting aflame the animal spirits, and buoyed the mood of the markets.

2. Accommodative monetary policy made money cheap, and in combination with the buoyant mood and the animal spirits, led to compressed risk premia in the capital markets. Think insatiable demand for IPOs, and Fed rate-slashing due to LTCM in 1998.

3. Sensing opportunity (and driven to madness by their proximity to money with no ability to make it themselves), those in charge of telling the truth, like auditors, started fudging things in order to keep the good times rolling and to get a slice o’ Cheddar for themselves. Think Arthur Andersen and Enron.

Now, let’s take a look at Housing in 2002-2007.

1. A real change occurred. Think a palpable change in national mood and priorities post-bubble and post-9/11. In the realm of personal finance, we saw an aversion to “paper” assets and a move toward the real and tangible. To many people, this meant plowing what was left from equities into real estate, which had already been enjoying decent returns from the wealth effect of Bubble 1.0.

2. Accommodative credit. Think not only macro level, Fed funds rate stuff, but no-doc loans, NINJA (no income, no job or assets) loans, ARMs, option ARMs, interest-only loans, etc.

3. The truth-tellers started lying. Think the house appraisers here who were being incentivized to keep the party going at risk of losing business from the real estate agents, and the mortgage “officers” who were effectively the “buyer apraisers,” incentivized to keep the party going directly due to fee structures. Nobody in either group called foul on the prices or the creditworthiness in question.

This formula works pretty good, although it’s loose enough that its predictive power is probably fairly weak (better for validating a thesis than for scouting out a new bubble in progress). Any other ideas as to bubbles where we can look for these factors?

Textmate Cheat Sheet

  Option+PgDn    Page down while moving cursor (caret)  Esc            Autocomplete  Command+/      Comment/Uncomment (Ruby, at least)  Ctrl+Command+V Paste without reindenting   

VCs and the Naughty Bits

I spotted a piece by Paul Kedrosky today during a blog-feeds-catchup-session where Paul talks about a sort of “(minimum) two degree of separation” rule that VCs maintain between themselves and the sex industry. (Quotes above for my words, not his.) In other words: benefiting from infrastructure, transport, payment mechanisms — cool. Having fleshy bits linked to from the portfolio companies page — not cool.

This reminds me of an early experience I had at Voyager. We were looking at a company that was building an online search / social media app. They talked about people using it for various applications — consumer, enterprise, small business, blah blah blah. We were just about to the end of the pitch, when I asked pretty straightforwardly: “So, what’s the sex angle here? Is there an application in dating or porn?”

The room went silent.

I pushed on, oblivious to the mood that had just chilled like a shot of Jaeger down an ice luge. “You know, like VHS, or modems for BBSes, or early adoption of Web marketing tricks like affiliate programs and popups,” I articulated despite the intrusion of my foot now rapidly entering my oral cavity. “Is there a strategy for accelerating adoption around that content?”

The founders were visibly uncomfortable. Mercifully, my boss was not pissed, just bemused. “I … I guess people could use it for other things, too,” said one of the founders, finally. Handshakes all around, a quick note on our investment process, and we’ll get back to you after next week’s partner meeting, ciao for now.

Oops. Back at the office, this is addressed.

“Randall, in the venture business, we have certain things we don’t talk about, and certain things we don’t invest in, due to a number of reasons.”

At the time, I’m thinking: OK, VCs are pillars of the community, have to show up at the Opera, at the charity events, at the B-school reunions, and can’t be branded pornographer or such. I filed this away under the “shit not to talk about, Einstein” filter, along with ever admitting to listening to Journey, or denigrating tattoos while speaking to anyone whom you’ve never seen fully naked.

But now, Paul Kedrosky gives me a flashback and with a key piece of insight. It’s a follow the money moment: “… until the venture business is funded by groups other than pension funds, trusts, and endowments (ahem), the likelihood of mainstream VCs ever getting beyond flirtations [[with the sex business]] is vanishingly small.” Yep, follow the money. The paymasters here are the Prudent Men, the real stodgy guys, the Trustees and the Chairmen and the Stewards and the Overseers.

And frankly, this is probably a good thing. It’s a little like the Senate. You don’t want the country entirely run by a bunch of pasty old white dudes, most all millionaires, 60 years old and who won’t be fired for 12 years (on average), and who probably still think that Kudzu and the missile gap are our biggest national problems. But you don’t want a bunch of whippersnappers on the make driving all your big decisions without recourse to the accumulated wisdom of years past.

The real test will be if one of the trendsetter endowment funds like Harvard or Yale green lights a VC or PE investment that targets the sin sectors. If that ever happens, then the VC business will start to get a lot more (directly) involved in the naughty bits…

Liquidation Preferences: A Response to Leo Dirac

In a recent blog entry, Leo Parker Dirac poses the question of the fairness of liquidation preferences in VC financings of startups. He’s going to be delivering a lightning talk based on it tonight at Ignite Seattle.

(To those of you who don’t know, liquidation preferences, or prefs, are usually a multiple of invested dollars that a VC gets out first, before anyone else is paid. This is because if you take $10 M from a VC for half your company, then shut down the company one second after depositing the VC’s check, he would only have a claim on half of it, thereby snookering him out of $5 M. To avoid this outcome, and due to our general greed, we VCs like to ask for at least a 1.0x preference, meaning that you have no incentive to shut down the company until you’ve grown it to something more than our investment dollars.)

His conclusion seems to be that liq prefs can be fair if transparently communicated to all parties. Of course, this implies that sometimes, details of prefs are not communicated clearly.

How can this be? I’ve seen many tens of term sheets, and never once have I seen one that uses invisible ink. Neither have I ever seen a term sheet that has a clause invalidating it if you show it to your lawyer. In short, there is never a case where an entrepreneur isn’t reasonably informed about prefs.

Let me construct an example. Say that you’re a first-time entrepreneur, and that you don’t have anyone on your exec team, nor on your board of directors, nor among your existing investors, who’s ever seen a term sheet before. (I was in that spot starting my first company back in 2000, by the way.) And, let’s say, you get hold of a term sheet that casually throws out there something like “holders of Series A shall be entitled to an amount per-share equal to two times the per-share price…” and you don’t know what it means.

Well, one thing I can absolutely promise you is that no VC is trying to sneak one by you for a shot at 2x his money. A VC investment just takes way too much heartache and worry and effort — not to mention opportunity-cost of not investing in the billion-dollar blockbuster every VC’s looking for — for a VC to fuck around with taking a chance at cheating you out of a couple million (remember, he has to give all but 20% of that profit to his investors, and split that 20% through some formula of his partnership, so even if he cheats you out of $5 M he’s not going to deposit more than a few hundred $k in the bank, and that’s at risk of losing his several hundred $k per year sinecure for a GP of a decent-sized fund).

Another thing I can promise you is that no VC ever wants you to sign anything without reading it and having your lawyer read it twice. Think about this one for just a second: I’m about to wire you enough money to buy twenty or thirty Porsches, based on the notion that you’re a brilliant businessman who’s going to make us both rich. Do I want to give thirty Porsches worth of cold, hard cash to the kind of guy who signs deals without reading the contract??? Seriously: I want you to be the slickest of salesmen, the toughest of negotiators, and the most diligent of dealmakers (not to mention a prodigious engineer, a revered leader, and a master marketer). VCs do not want to give money to sloppy suckers who can’t be bothered to read and understand a term sheet — including seeking savvy legal counsel when appropriate!

Now, having said all this, there are at least two cases where Leo’s thinking really does apply to the question of liq prefs. (It shows of Leo that his thinking on the matter of prefs is mostly abstract, that he does not mention either of these two cases.)

The first case is where you are dealing with a fake VC. A real VC is someone who spends full time managing a fund of committed capital from one or more arm’s length investors, which capital amounts to at least, say, $10 M per general partner and is entirely meant to be invested in growth companies for the purpose of financial returns primarily via capital appreciation. A fake VC is anyone else who calls himself a VC without pointing out the major differences with the above. And a fake VC has God-knows-what sort of motivation and may well want to swindle you out of a preference multiple.

Your uncle who owns a chain of bagel shops is not a VC. A hedge fund is not a VC. A dude who claims to represent a group of “anonymous Asian industrial families” is not a VC. Anyone who is keeping his day job is not a VC. Real estate guys are not VCs. Note that this doesn’t mean they are bad people (unless they pretend to be VCs, in which case they are fake VCs). It just means that the ground rules that you can understand all VCs to play by don’t apply.

If you’re not dealing with a real VC, read everything three times and have your lawyer read it six.

The second case is in follow-on rounds where the company is in a distressed situation. Everything Leo talks about (and everything I assume in the first part of this post) is about the moment before you take your first VC investment: do I take this capital, with its strings attached, for a shot at building my dream? The alternative there is to simply walk away, and go back to working at Microsoft. But once you’re hot and heavy with a company, once you’ve raised money, promised the moon and the stars to your friends and family, bamboozled the VCs into funding you, alienated all your social contacts and exacerbated your RSI, hired fantastic people and worked them to exhaustion and made them love you enough to drink the Kool-aid, extended commitments based on your word and your honor to customers and suppliers — only to find that revenues aren’t ramping up fast enough and you need cash — OK, now you are officially up against a wall. And precisely now is when you will be addled from overwork, and adrenalin-high, and blinded with the urgency of your need — and when the sharks will smell blood.

That is when you will get the predatory term sheet.

If Leo wants to do entrepreneurs (and VCs) a favor, he should take a hard look at what happens then: when you’ve got a company that still holds promise, but is in a distressed situation and needs capital for its very survival. Exploring those moral complexities is a lot more interesting than the sort of clean-room, game-theoretical chatter about whether one accepts term X on a first round of capital.

Rails form_tag Changes in Rails 1.2

I recently updated my dev machine (Mac OS X) to the latest Rails gems, and was getting deprecation warnings for using form_tag in its old, non-block, pre-Rails 1.2 way.

Then, in moving between my development and acceptance-testing boxes (you do have a mirror of your production environment running as an acceptance testing server before you push things from your laptop to production, right?) I started getting blank HTML pages out of the testing box. Whoops.

Well, one thing is that the two different versions of form_tag act differently with respect to output — so with the old one, you needed to put:

<%= form_tag ... %>  

While the new one takes:

<% form_tag ... do %>   ... <% end %>  

(Note lack of = sign in the new, block version.)

But that wasn’t it. My problem was that, even with the equal signs fixed, I was getting no love from my testing box. Things that should have been enclosed in the form tag block were just not happening.

My hunch was that the old version of Rails was barfing (this was sort of true: the new block form of form_tag is not backwards compatible). I updated Rails with a one-two punch of apt-get update; apt-get upgrade mixed with a gem install rails. No luck. Aha! Have to kill and restart the server process: still, I got no form tag love.

I checked the Rails version with rails -v and got 1.2.3, the latest version. gem list showed that 1.2.3 was coexisting with some older versions. Aha! And a real aha this time — for this was, it turns out, the problem.

Thanks to the folks who author the acts_as_authenticated wiki. It was there that I found a reminder that the RAILS_GEM_VERSION variable, in config/environment.rb, can be set to peg which, among several possible installed versions of Rails, the app will use.

It appears that if you comment out RAILS_GEM_VERSION, you get the latest installed version — which in my case fixed it to use 1.2.3, thereby giving me my form_tags back.

God Help You If You Get Derailed: "Model is Deprecated"

The comprehensible but often superfluous model method in Rails is used in an ActionController to tell it about an ActiveRecord model that it ought to have loaded in order to have the AR classes available to it. It’s kind of got the feeling of a require or a use in Perl. It’s fairly straightforward to reason by analogy about what it does.

(The only confusing thing, I think, is that it works by imputing a filename from a symbol representing the class to do its “magic” so if you define multiple AR classes in a single file, you’d want to make sure that the symbol that matches the filename containing the multiple classes is what you pass to the model method.)

But in a nutshell, you stick model :my_object_class in, say, the base ApplicationController class and you’re good to go to use MyObjectClass and any subclasses defined in the same file.

Well, it was the way you do it. Around Rails 1.2, it started barfing up preemptive deprecation warnings: model is deprecated and will be removed from Rails 2.0.

So, you follow the URL they give you for more info. Unhappily, nowadays (August 2007), the page they point you to, http://rubyonrails.org/deprecation, doesn’t say anything about model. WTF, guys?

Googling around tells you that you should use require_dependency instead. Oh, good. Way longer to type and harder to remember, but it’s OK, because require is part of the language itself and is familiar to those who understand it. Er, wait: it’s require_dependency, not require: it’s a Rails feature, not a Ruby core language feature.

Fine, you say, I’ll do it if I must. Just do a replace on those lines, and you’re good, right? Oh, wait again, now my app is bombing with an error 500, and the log says undefined method `ends_with?' for :my_object_class:Symbol. I won’t keep you in suspense: you can’t give a symbol :my_object_class to require_dependency, you have to give it a String ("my_object_class").

All of this highlights a pretty big issue with Rails. It’s really an infantile, nascent culture. To keep up with it, you really need to be in constant conversation with the community (like constant: I mean, you need to be sitting in the session at RailsConf with Colloquy open on your MacBook, chatting about stuff on an hour-by-hour basis). This isn’t bad, but you better understand it. And you better be refactoring your app constantly in order to keep up with best practices and to be able to use new plugins, etc. — which also isn’t bad, but it’s expensive and a hassle.

And to anybody who thinks a Perl app is tough to maintain: yeah, right. Try Rails code from a year or so ago if all you know is Ruby and you haven’t been heavily engaged in Rails culture during that time.

“Convention over Configuration” is fine and dandy as long as you’re steeped in the culture that maintains the shared conventions.