Musings of an Entrepreneur

                                                 

I am skeptical about all the hype around Twitter. I like Twitter and find that it’s an effective way of letting my followers know what I am up to, but it’s not much more than that. It’s not a great real time search engine. The information is too “spammy” and confusing.

The hype around Twitter reminds me about the hype around SecondLife a few years ago. SecondLife has turned into a great business, but it has not revolutionized the Internet or social networking. I suspect Twitter will become a successful business as well, if only by putting Adsense around its search results.

However, I have a hard time seeing it become more than that. It’s just not as useful as a site like Facebook. I had a similar criticism of SecondLife. Contrarily to a game like World of Warcraft, SecondLife has no objective which makes it harder to retain user engagement.

Comparing Facebook and Twitter, over 50% of Facebook’s 200 million active users login every day. 60% of Twitter users stop using it after a month. I personally find Facebook much more relevant to my personal life – I like seeing pictures, relationship status changes, etc.

They might confound me, but my bet is that will become a successful interesting site, but not much more than that.

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wingsuit base jumping from Ali on Vimeo.

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I had the pleasure of being invited to a New Media dinner at Strauss Zelnick’s apartment in New York. It was a fantastic opportunity to reconnect with old Internet friends and to meet a slew of interesting characters. Jason Hirschhorn formerly from Sling Media was easily the funniest person in the room and made quite an impression with his stories, humor and impertinent yet astute commentary.

After the dinner, we all partook in a discussion on the future of media moderated by David Remnick from the New Yorker. The discussion ranged far and wide from Fred Wilson’s “There is no truth, I only want to read what the masses are thinking” to a few journalists from the New York Times and the Wall Street Journal vehemently defending the value of investigative journalism. Jason reminded us of the fantastic Epic video that emerged a few years ago where Google caused the demise of the New York Times which at the end became a newsletter for the elite.

There is no denying that the newspapers are under threat as they have never been before. They are facing increasing competition on the distribution side from the Internet while classified advertising and print advertising revenues are going away. Newspapers represent 3% of media consumption and 17% of advertising revenues while the Internet represents 20% of media consumption and 5% of advertising revenues. It’s not hard to imagine those shares of advertising revenues inversing.

Given the threat to the very existence of newspapers, many voices emerged defending the public value of the big brand newspapers, especially the New York Times, the Washington Post and the Wall Street Journal. While their best days may be behind them economically speaking, I am actually not worried about the survival of these newspapers. Their business model significantly worsened, but it does not mean they will go away. Airlines provide a nationally critical service. The industry as a whole has not been profitable over its entire history, yet they manage to survive. The same will be true of newspapers, even if it takes a few billionaires subsidizing them during the transition period.

There definitely seems to be a market for well written and researched papers and magazines. The Economist is currently increasing its readership and the Wall Street Journal is doing relatively well. One could even argue that the demise of local papers will strengthen the large brands.

It’s hard to tell where the media world will end up 25 years in the future. As someone pointed out, 10 years ago AOL had half the Internet and Infoseek, Alta Vista, Lycos and Geocities were the talk of the town.

There is no doubt the transition will be painful, but I am convinced there is a market for well researched reporting and I can’t wait to see how it all pans out!

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Over the past few years, my angel investing strategy has been to be very selectively aggressive. I would invest relatively large amounts of capital in very few companies and typically sit on the board as well. I believed that my ability to identify unique companies and help them out would lead to outsized returns. Over the past few months, I have fundamentally revised this strategy.

I have had the pleasure of interacting with a large number of angels with numerous investment strategies. Without fail, the companies that succeeded for them were never those they might have expected to succeed the most at the time of investment. Their success as investors most often came down to luck and did not seem correlated with the intensity of the due diligence they had conducted or a priori quality of the management teams they had backed.

Given the hit driven nature of the angel investing business, it’s important for angels to have at least one hit in their portfolio to cover the losses from the duds. Angels who, on average, had invested in less than eight companies lost money on their investments, while those who invested in more than eight companies on average made money on their investment.

By May 2008, I had invested in 6 companies and sat on the board of 4 of them. Since then, given how busy I am with OLX, I have scaled back my existing board involvement dramatically, divided my average investment size by a factor of five and I am now invested in 15 companies. I have not joined the board of any of the new portfolio companies and don’t intend to for future investments either.

I invest mostly in early stage startups at the seed level as I think it’s the least efficient and most fragmented stage of the investing process. Series A rounds and beyond are well covered by venture capital and private equity firms and are much more competitive. I focus on direct to consumer businesses both because I understand the space better and the due diligence is significantly easier to do (why active entrepreneurs mostly invest in consumer internet companies). I also often invest in companies off the beaten path (outside of Silicon Valley and often outside of the US) reflecting a small comparative advantage in international sourcing because of my background.

In the past few months, I added another constraint. Given the likely dearth of venture capital investments in 2009 (why VCs invest less in downturns), I am currently only investing in companies with very low capital requirements that are likely to reach profitability on the seed funding. I also insist on very low valuations (often much lower than $1 million pre-money) to compensate for the likely increase in default rate caused by the lack of funding and potential acquirers.

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After all the dire warnings given by various VCs, here is a more positive list of recommendations sent from one of my friendly VCs:

1. Don’t panic! Economic cycles are part of life. Best companies are built in the worst of times. If you panic, your employees will panic.
2. Conserve cash. Delay spending on non-critical things that do not result in revenue generation. Renegotiate vendor contracts, rental contracts, etc.
3. Improve productivity. Get more out of your team.
4. Differentiate between high and low performers. Reward the high performers. Counsel out low performers.
5. Optimize the organization. Hire critical talent as they may be available at a reasonable cost. Transition or re-deploy non critical resources.
6. Continue selling and marketing your product or service. Being in front of customers and vendors builds confidence that you are a long term player.
7. Focus on growth with an eye on profitability. Since the cost of capital is high today, be cautious on how much capital you raise to invest for growth. Avoid over-investing in the business in the hope for exponential growth in the future.
8. Communicate with your team internally. It Make sure your team understands that you are building a lasting and successful enterprise and that some of the cost cutting measures including layoffs are necessary for the health of the company. Anxiety levels can be high in tough times.
9. Act swiftly. Try to deliver any bad or tough news at one shot to the company. Continious bad news can affect morale and instil fear.
10. Have fun! Make sure your team is having fun. A happy environment builds loyalty and performance for the long term.

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Last March I explained why startups should raise as much money as possible to prepare for the upcoming crisis (Why the startup market is like the real estate market). Now that the crisis has hit, we can examine what it means for entrepreneurs.

1. Aspiring Entrepreneurs:

There is no better time to start a company!!

The opportunity cost has decreased as many high paying jobs have disappeared and employment opportunities in general have lessened. If you have a job, companies will have less room to give generous bonuses and/or raises.

It’s going to be harder for entrepreneurs to raise money, but competitive pressures decrease dramatically in downturns giving you more chances to establish yourself as the leader in your field and more time to do so. When I created Aucland, a copy of eBay for southern Europe in 1998, we faced dozens of VC backed competitors in every major country. We wasted millions of dollars in advertising to establish ourselves as the leader.

When I launched Zingy in September 2001, we essentially had no competition. The online advertising market had completely dried up allowing us to buy billions of advertising impressions for $10,000! The lack of competition proved critical to our success given that it took two years for the company to start establishing itself in the marketplace.

If you have been thinking of creating a company, now is the time to make the plunge!

2. Poorly Capitalized Startups:

My definition of a poorly capitalized startup is a startup with less than 1 year’s worth of cash on hand. A company may have $100 million in the bank, but if it’s burning $20 million per month, it’s poorly capitalized. If this is the predicament you find yourself in, I will reiterate the recommendations that most VCs have been giving to their portfolio companies during the past week: cut your burn as much as possible as fast as possible:

• Stop marketing unless it has a proven positive return on investment
• Lay off anyone non essential
• Focus development on the most important features
• Consider salary cuts for the top management and anyone highly paid
• See what payments you can defer

Only profitability will put you in control of your destiny!

If you have not seen it, check out the Sequoia “RIP: Good Times” presentation.

3. Well Capitalized Startups:

If you have more 3 years worth of cash on hand, you are well capitalized. Given the current environment, you may very well need it and I would advise you to heed many of the recommendations I mention for poorly capitalized startup in terms of keeping lowering your burn and aiming for profitability. However, I would recommend being selectively aggressive.

It’s when everyone else is cowering and sitting by the sidelines that the best opportunities arise. For Internet startups, they usually come in the form of inexpensive acquisitions and marketing. That time has not yet come.

In terms of potential acquisitions, many entrepreneurs have not adjusted to the new reality and many startups have not run out of cash yet. This opportunity will come in 2009 and/or 2010. In terms of marketing, the time has not yet come either. Many media buys are committed to ahead of time and will probably run until December. In 2009, the opportunity may appear to buy a lot of traffic cheaply. You will notice it when if your average cost per click decreases significantly in your Google AdWords campaigns.

In the meantime, cut costs and be patient knowing that your time will come!

Conclusion:

The economic environment has been radically altered fundamentally changing conditions for startups. Valuations will decrease. M&A activity and IPOs will decrease. The average life cycle of a startup from inception to exit will be much longer – over 5 years. In this environment, only the truly committed should venture. Your mettle will be tested and you will need all your grit, tenacity and passion, but if you stand the test of time and take advantage of the opportunities the crisis offers you, you will be richly rewarded!

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It annoys me to no end that even as banks have massively diluted their shareholders to raise capital, they are still paying dividends. In the current environment they should focus all their efforts on capital preservation. They should completely eliminate their dividend. Besides, given the number of new shares they have issued, cutting the dividend per share by a certain percentage, does not decrease the cash outflow by that percentage.

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By Stacie Rabinowitz

So I mentioned to Fabrice that I had been explaining credit default swaps to a friend of mine without a finance background, and he asked me to be so kind as to explain it to those of you who are also a bit in the dark about what these things are. Mostly because he’s too lazy to do it himself :)

To put in the usual caveats: I took finance in business school, and I’ve run this by enough bankers who agree that I seem to know what I’m saying that I’m pretty confident I have my facts right, but I have never worked with them in real life and so would love any corrections from those of you actually in the industry. Also, I am going to try to explain why I think there should have been more red flags raised about them. Yes, I am sure they had a valid functional purpose for a small base of consumers, but I think that at this point we can all safely agree that they were overissued and overtraded and in my opinion there were some warning signs to this long before banks started going under.

So what exactly is a credit default swap? Mechanics aside, functionally it is like an insurance policy for a bond. You pay someone a small premium so that if the company that issued the bond goes under, you at least get some of your principal back from this second party. It’s kind of like if I lent Fabrice money, and even though he was paying me interest on it, I was worried that with his risk-loving lifestyle he might die before he could pay me back. So, if I took out a separate insurance policy on his life so that I got my principal back (or a portion of it) in the event of his death, that would be a credit default swap.

Problem #1: A credit default swap is not actually a swap. I’m sure that the mechanics of the transaction make it a swap, but functionally it’s really an insurance policy. You can tell because many banks were making a lot of money off of them, and theoretically swaps are supposed to be zero-cost: you swap the returns on two assets, but you are also swapping the risks, and therefore the compensation for them. A typical swap: Fabrice is a French citizen, I am a US citizen. I have a company I want to start distributing wines in France, but I need French citizenship to get government approval because they’re so particular about their wines. Fabrice wants to copy someone’s successful French company in the US, but he doesn’t get the best tax breaks because he’s not a citizen. So I start Fabrice’s company, he starts mine, and we agree to swap the returns. They’re equally risky ventures, so we don’t exchange any additional money. The fact that so many people were making money off of these credit default “swaps” should have alerted someone to the fact that they were not really paying off like swaps at all, and the fact that they were being called swaps anyway, hiding their true function, meant something fishy was going on.

Problem #2: Corporate bonds pay more than US Treasury Bills (the so-called “risk-free” asset). There is a decent probability that corporations will go under and not be able to pay back their debt, whereas there is a much smaller probability that the US government will. This difference is why corporate bonds pay more than US Treasuries – investors are being compensated for their risk. The more likely a company is to go under, the higher the payouts to the bondholder because of the higher the risk the investor is assuming. Now, if I’m paying someone money to insure my bond, I am trying to buy away that risk. The value of the insurance payment should be exactly equal to the difference between the payoff to the bond and the payoff to a Treasury Bill. If I wanted to be protected against my investment counterparty going under, I should have just bought a Treasury. To use the Fabrice example from above, if I was worried he was going to die before he was able to pay me back, I should have just not lent him the money. Expected payoff from Fabrice = Value of payment * (1-probability of his death). To make this equal to the amount I could have gotten investing my money in a Certificate of Deposit at a bank, I would have to charge him extra to compensate me. This extra would be exactly equal to the insurance cost, since the company would only sell me a policy for Value of payment * (probability of his death) in order to make money. So if investors are finding it more valuable to buy the bond + CDS instead of a simple Treasury, it means that something in the market is probably mispriced. And in finance, mispricing either gets cleared out really quickly or leads to big trouble.

Problem #3: The market for these devices has been reported to have been huge multiples of the value of the underlying assets. In other words, there is $1000 being floated around in investments that pay off in case Fabrice dies based on him not being able to pay back my loan, but the loan was only $50 to begin with!

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I am not quite sure what the starting salaries are at management consulting firms these days but for argument’s sake let’s say it’s $50,000 for analysts and $100,000 for associates. Given that management consulting firms “rent” their services for at least 5 times the employment costs, the downside of being understaffed is much greater than the downside of being overstaffed. As a result, they will always be over-staffed at the beginning of a recession.

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Given the rave reviews I expected something a little better. The story of single player campaign is absolutely fantastic. However, the graphics are a bit fuzzy at times, especially when driving. Worse the multi-player system is clunky. It’s hard to get games started with your friends (few others join) and the game is not nearly as playable as Call of Duty 4 in multiplayer.

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