Fabrice Grinda

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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It’s odd to me that their opening bid was at $31 per share given that the stock was trading at $19. I don’t see why they did not offer a 40% premium – say $27 and give themselves room to negotiate upwards with everyone saving face.

Instead they offered $31 and said it was their final offer, which was not credible. They now will end up paying much more and have to deal with all the bad blood they created in the meantime.

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I have to admit Allmydata (www.allmydata.com) has had a rough time. The original team had difficulty executing on the vision and most had to be replaced. Using a peer-to-peer client to have lower bandwidth and storage costs and hence lower pricing have not been a comparative advantage in an over-funded world where many money losing free competitors have emerged. Moreover, despite the security and encryption users hated the idea that their files were stored on other people’s computers. The product we had originally devised was much more difficult to use than we had anticipated. Frankly the software was slow, bloated and buggy!

Over the past year we rebooted the company. We changed the team, rewrote the specs, redesigned the product and changed the business model:

• We redefined the problem Allmydata is trying to solve: Allmydata is the solution for online storage, backup and sharing.
• The way we decided to solve this problem is by building a virtual drive on your computer that acts exactly like a regular drive if you use the Allmydata client:
1. Allmydata shows up as a drive
2. You can store as many files as you want of any type
3. You can run files directly from the virtual drive or copy them to your local drive
4. We decided not to build our own backup application, but instead to integrate to the backup applications built into Vista, XP and Mac OS or allow users to use any backup client they want
5. We created a web interface that looks exactly like the client to give remote access to files without needing to download the software client
• We simplified the business model dramatically removing tiered pricing and offering an all you can eat plan for $4.99 per month for unlimited storage with a 1 Gb free plan.
• We removed peer to peer from the downloadable client as it was too resource hungry and slowed uploads down dramatically. We did keep it on our back-end to split the files on our own servers to allow us to use cheap Linux boxes and hence have much lower costs than all our competitors, Amazon’s S3 included.
• We rewrote the software client such that memory usage went from as much as 200Mb to less than 30Mb.
• Simultaneously with the Allmydata 3.0 release we are releasing a beta version of the Mac client both for Tiger and Leopard.

All the changes above happened incrementally over the past year or so. None of them on its own was a game changer, but we would like to believe that the sum total of the improvements create a “Skype-like” (meaning easy to use and understand solution) for users’ storage, backup and sharing needs.

We’ll see what the future holds but for the first time in a long time, I am becoming optimistic about Allmydata!

Try Allmydata 3.0 now!

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Nine months ago we moved all of OLX to Jira (http://www.atlassian.com/software/jira/). We are extremely satisfied with the product.

It’s extremely important to input every single project your tech team is working on. If you don’t document very small bug fixes and changes, you can end up having a large portion of your tech resources on projects that may or may not be very important.

Also note that online project management tools like Jira and Trac (http://trac.edgewall.org/) are much more useful than PC based solutions. Everyone always sees the latest version of all the projects. Developers assigned to a project can comment on it or update the status in real time. Managers can update specs and track their projects.

There are many ways to organize your release schedule to fit your organizational needs. At OLX, releases are on an ad hoc schedule, but we average a release every 2 weeks. We also have a weekly product meeting where we cover what was released, upcoming releases and adapt project priorities as needed.

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Despite my previous post on the gloomy outlook for startups for the next 12 months, I am more bullish than most on the online advertising market.

Advertising expenditures have a tendency to decline during recessions and the online advertising market collapsed in 2001 after the Internet bubble burst. However, I predict things will play out differently this time. The online ad market is not supported by billions of dollars of silly VC money as it was in 1999.

Companies now have the tools to monitor the ROI on their online advertising. As such, if anything a recession would probably accelerate the transition from offline advertising to online advertising as companies become more ROI focused. Given that online media represents about 20% of media consumption but only around 5% of advertising spending, it still has a lot of growth ahead of it.

That is not to say that growth is not going to slow down. The largest budgets are still controlled by big brands and agencies who don’t invest much online yet and who are going to be even more risk averse in a difficult environment, but the trend from offline to online is inexorable.

Google is going to great pains to make online advertising more attractive to advertisers. To decrease accidental clicks they recently changed their AdSense policies to:

• Clearly separate Google Ads from the content of the web site
• Enforce more standard Google Ad formats
• Only make the title and the link clickable in the ads (and not the text description or the entire row)

All those changes decrease the click through rates on their ads, but should increase conversion rates for advertisers which in theory should allow them to bid more on keywords. All those changes are bad for revenues in the short run for Google and its AdSense partners, but should pay off in the long run.

Conclusion: The recession will decrease the short term growth rate of online advertising, but accelerate the transition from offline advertising to online advertising.

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