Week 23: Sourcing, Screening, Valuing and Pitching

Stanford GSB Sloan Study Notes, Week 3 (23), Winter quarter

A large group of Sloan Fellows honoured Martin Luther King Jr on his day by driving up to Lake Tahoe. It was great to find out that snowboarding is like riding a bike – fun even despite of the ~7 year break I had.

The classes on free Mondays are not cancelled at Stanford, just moved to normally “open” Wednesdays. As a result, the past four working days were just insanely busy at school, but I fortunately still managed to make it to a visit to Dropbox HQ and attend a demo days preview at 500 Startups.

Covered in this issue:

  • Nuances of valuing bonds and stocks
  • Venture capital pipeline sourcing and screening
  • Avoiding the pitfalls of pattern recognition in picking VC investments
  • Managing a venture portfolio through economic crisis
  • Pitching tips
  • Creating a consumer brand of tech components and using social media
  • Eric Schmidt was back in his co-teaching class + many guests from Illuminate Ventures, Highland Capital, Accel, Intel, Klout, Gilt, Edelman

FINANCE 229: Sloan: Core Finance (Strebulaev)

Valuing Bonds

  • Total volume of bonds is 50x total volume of equity in the world. The trading volume of US bonds is 10X equity trading – and that is a country with well developed markets (ratio much worse in Germany)
  • Wrong to think of (government) bonds as risk-free, more precise to say they are default-free.
  • Even though zero-coupon bonds do not carry interest, you are compensated for the time value of money. (e.g, you can purchase a $100k bond at initial discounted price of $96.5k) This return is what is used as a “risk free” or “spot” interest rate benchmark in valuation calculations.
    • For zero-coupon bonds the sensitivity is approximately equal to years to maturity: price of a t-year bond will rise by about t% for each 1% drop in interest rates.
  • Think of coupons as shortening the maturity date (as cash flows are brought forward, present value of future coupons heavily frontloaded). The shorter the term, the flatter the yield curve (less influenced by changes in interest rates)
  • Any bond price can be converted to yield. Yield more commonly used in quotes by bond traders, on bond markets usually price as a percentage of the bond’s face value (e.g 94.498 implies an actual price of $944.98 for a $1000 face value bond).
    • When converting, important to note if yield numbers are per period (quarterly/half year coupon payouts) or APR.
    • Coupon rate is by notation expressed in APR, as a percentage from face value (not current price).
  • If a bond’s yield to maturity has not changed, then the IRR of an investment in the bond equals the yield to maturity no matter when you sell it.
  • Empirically, the number of creditors is the leading explanation to recovery rate in bankruptcy – the larger, the more complex the coordination.
  • Changing the interest works as a macroeconomic lever because it automatically changes the NPV calculation of all projects in the economy in the opposite direction (lower interest rate -> higher NPV -> more investment projects profitable to be launched)
    • Interest changes are more effective lever in crisis management because of the shorter lag than for example tax changes
  • Using IRR for bonds is fine, because the cost (cash out) is always front loaded.
  • Bob Citron of Orange County – bond arbitrage gone wrong

Valuing Stocks

  • John Burr Williams‘ Theory of Investment Value (1938) – the founder of fundamental analysis, using pro forma modelling, mathematic methods
  • Enterprise value intuition: buy a company, take all of its cash and pay off all of its debt. The remaining operational business, without any leverage = EV.
    • Firm value = EV + Cash.
  • WACC (weighted average cost of capital) is used as a discount rate when a firm is financed by both equity and debt.
  • Large part of a drop in acquirer’s stock price drop in M&A is explained by the winners curse – the one who won a bid, quite surely overpaid (the larger number of participants, the more aggressive bidding needed). Mitigation by sanity check questions:
    • why am I investing when competitors don’t?
    • why do I think the opportunity is huge?
    • why do I believe the time to invest is now?
    • Create several small teams which only merge to justify/defend/aggregate after arriving to decision/valuation/solution in isolation
  • Common value vs private valuation – do all bidders value the target by the same measure? In short, if you honestly think you’re using common value (no synergies) – get out of the auction.
    • Evidence shows that private equity firms are hit more by winners curse than strategic acquirers, because they don’t have unique synergies (the value-add work they can do, any PE can do)

FINANCE 373: Entrepreneurial Finance (Korteweg)

Case: Illuminate Ventures (case itself in beta & not distributed yet)

  • When raising a first-time fund, a new VC needs to balance their differentiating focus not painting them into too narrowly limiting niche. (How do you present your focus on gender-diversified founder teams VS getting tagged as “chick fund”)
  • Woman-led high tech companies: 1) deliver equal or superior financial performance; 2) fail less frequently – offering lower risk than non- diverse leadership teams; and 3) are more efficient in their use of capital – reaching the same level of performance in early years with 30% less capital. (Cindy Padnos, “High-Performance Entrepreneurs: Women in High-Tech,” Unpublished White Paper, 2010)
  • “Pattern recognition” as a screening method is the main contributor to homophily in investing pipeline.
  • 200 women cofounders from over 125 companies have led their company through an IPO or M&A exit of $50 mm or more over the past 10 years
  • Emerging manager = VC fund with <$300M under management and in its 1st..3rd fund. As often too small for large endowments to invest directly (at $50-100M minimum), managed through emerging manager fund-of-funds. Attraction for large money by diversification and being potentially a “step ahead” investment trends wise.

Guest: Cindy Padnos (Illuminate Ventures)

  • Didn’t create a fund to invest in women, but to a) understand what the barriers are and b) how could overcome them without ever having gender as anything mentioned in the investment thesis
  • In the changing early investment scene (super angels and mega funds) it can be a differentiation in itself to be “like the VC industry started”. Partners with strong operational experience, active involvement, clear thesis, etc.
  • As an entrepreneur you get one clean shot with a VC. You go in with a proposal, you get either immediate due diligence or a no. Now when the VC goes to the LPs to raise money, it is a much more complex picture – many players, many lengths of decision making and discussion processes.
  • Many VC firms contractually limit their GPs taking their past track record and attributions along should they want to go and do their own fund.
  • When recruiting advisors, set very clear targets. 6-8 people per category, for ex “founder CEOs who have had a $50M+ exit in B2B tech space”. Other groups: corporate executives, startup ecosystem players, academics.
  • Some funds use for advisor compensation – option to invest in a parallel fund with lower than usual management fee & carry, without minimums.
  • Starting with a whitepaper on your investment thesis could help to establish you as a thought leader in the space (good for deal flow, fundraising)
  • There is data on funds with at least one female partner making more investments into women entrepreneurs. But it is not that one woman leading the deal, but the presence of a woman on team already reflects the entire firm’s (incl male partners) biases and mindsets towards diversity.

Reading: How Venture Capitalists Evaluate Potential Venture Opportunities (Roberts, Barley 2004)

  • As a rule of thumb, enterprise software can not sell for less than $200,000 and still afford a full-blown direct sales force.
  • Test question: is Fortune1000 the target for this product? Only then multiples can get to $500M-$1B total market size.
  • Corporate CIOs, VPs of IT, etc have 2-3 priorities they are willing to throw millions at to solve. Beyond this shortlist, a $20,000 software might not even hit their radar.
  • Of all decisions turned down for valuation, 10% are bad in retrospect. Of decisions turned down for lack of market, 1% is bad. Markets trump people trump technology.
  • Watch out for hidden liabilities when doing a due diligence for a company which has been living hand-to-mouth for a while.
  • Bottom-up analysis for the revenue ramp is always a fraction what the top-down is.

Case: Highland Capital Partners: Investing in Cleantech (Lassiter, Kiron 2011)

  • Diversifying between sectors inside a VC firm enables cross-sector benchmarking and more flexible overall fund strategy. Less volatile returns attract long-term LPs.
  • Using CEOs of portfolio companies as experts when looking at adjacent subsectors
  • Cleantech is not an industry nor a sector, it is rather an amorphous movement
  • Cleantech companies have low market risk for the commodity energy markets
  • Distinguish clean tech investments by supply-side (capital intensive, might not fit VC models) vs demand-side (demand management & efficiency, building management, last mile smart grid, software-based, etc)
    • “The cheapest kilowatt-hour of energy you’ll ever get is the one you didn’t use”
  • Edison would recognise the electricity grid to day, whereas Bell wouldn’t recognise the phone networks
  • It used to be that information was expensive and energy was free – now reverse

Guests: Paul Maeder, Alex Taussig (Highland Capital Partners)

Other:

  • More potential agency issues between GP & LP:
    • “Grand-standing” – exiting investments earlier (than would be most beneficial to LPs) to show returns in marketing their next fund
    • Allocating investments between funds concurrently open. If fund 9 is under anyway and 10 is more promising – let’s allocate lemons to the earlier to get them over with? Or vice versa, let’s try to distribute potential large winners to different funds to even multiples over time?
  • Early/Accelerated carry – a mechanism where GP can distribute carry to LPs early (annual basis), before waiting for later deals to exit. If the later exits fail, there are clawback clauses to returns some pre-paid carry to GP.
  • “Catch-up” clauses where GP gets exclusive distributions for a while once LP’s return of capital + hurdle have been covered. After catching up, distributions become the usual (80-20) split again
  • The Economics of Private Equity Funds (PDF) (Mertick, Yasuda 2010)

FINANCE 385: Angel & VC Investments (Strebulaev)

Guests: Sameer Gandhi (Accel, Sequoia), Sara Lannin (Accel), Peter Ziebelman (Palo Alto Venture Partners)

  • Why be a VC? You never know which extraordinary person will you meet the next day. And you get to relive the growth and exit through an IPO many more times than you’d likely get as an entrepreneur.
  • When visiting a company, arrive early, chat with the admin (who knows everything about a company), listen to the ambient buzz in the office
  • You’re in a good place if the founder drops you an SMS to have a 5-10 min call to discuss something every week
  • Even when you’re “better friends” with another co-founder, always work through the CEO to avoid disempowering him/her
  • Associate used to mean “partner in making”, but the VC org models have evolved in different directions, many have more operational people in house, etc
  • Expand your notion of “founding team”, not just the cofounders, but the first 10-12 people. They set the culture of the company and should be very carefully recruited – makes sense for VC to help to the point of interviewing first 20 (major time investment!). On flip side, for an aspiring entrepreneur, joining some startup among this first 10 might be as satisfying.
  • Companies have a certain amount of energy – they can either use it to go after the users & markets, or they can use it internally for bureaucracy and infighting
  • A story of a startup who hired a Taskrabbit to make it look like many people are hanging out in the office for the VC visit
  • Don Valentine asked entrepreneurs to write their business down on the back of their business card. Surprising how many couldn’t do it.
  • Take notes in pitching – if you consistently are asked the same question on slide 3, don’t answer “I’ll get to that later” more than once, change the deck
  • First email filtering criteria: What is the authority/trust of the person is it coming from? What does it say about people, market (business model & competition), idea and traction?

Read: Venture Capital Deal Sourcing and Screening (Strebulaev)

  • In 2010 US venture capital, 29% of all deals & 39% of total investment was in Silicon Valley
  • Accel Partners: Evaluating a Venture Capital Firm to Meet Your Company’s Needs (PDF)
  • Parameters considered in initial screening for fit:
    • stage of development: from seed to growth/pre-exit phases, risk & expected returns decrease as required sums increase in later rounds
    • investment size: minimum to be worth it; expected total over several rounds. For example, a $200M fund looking to invest $6-10M per company would consider $3M for initial investment to leave room for follow-ups.
    • industry: for overall firm, as well as a particular partner
    • geography: investing far from home increases notable friction to providing non-financial value
  • An example of a “company potential” formula: Market Size x Market Growth x Company Contribution = Company Size.

Read: A Day in the Life of Venture Capitalist (Hoyt, Gouw, Strebulaev)

  • Finding new investment opportunities is an individual task, whereas analysing and making decisions are processes that benefit from team view. Yet full consensus is also a yellow flag – if everyone agrees, maybe the deal is too safe, not edgy enough?
  • The dream timing for VC is to evaluate a sector that is so new it doesn’t have a name yet, and no players in it have received institutional investment (voice mail in 1980s, internet in early 90s
  • Established companies as deal source: who do their insiders see as the most exciting players on their platform / ecosystem?
  • Experienced entrepreneurs often want to deal with general partners, because associates won’t be making decisions anyway. Young entrepreneurs, in turn, might find first contact with an associate less intimidating.
  • Start working on founders/early employees of an acquired companies early to not miss their next venture (often 12-24 months ahead, depending on lockups, etc)
  • Entrepreneurs who are talked about, but refuse VC money can often be a very lucrative lead: less competition, strong signal of founder commitment, potentially something very novel going on
  • Use emotional gut feeling questions to double-check your intellectual analysis. Would you personally join this company in the founding team? If not – what don’t you like? People? Culture? Business? Why are you investing, again?
  • Common to have 3 company presentations on Monday partner meetings, 1.5h/each for sufficient time for partner questions.
  • Early stage board meeting cadence is usually 4-6 weeks, only later evolving to quarterly. A single meeting often takes 6-7 hours (prep, local travel, meeting itself). Multiplied with ~10 board / active observer seats it adds up. And big reason to keep most of your companies local.
  • Incumbent VC going along to pitch meetings in later rounds is a suspicious sign. They usually provide intros and references. And their incumbent presence increases the perceived value of the deal for newcomers anyway. For founder, keeping them in separate rooms creates more competition and less collusion.
    • Handling the “Who else are you talking to?” – OK answer: “A few other funds, but I’m not willing to share more at this time. Right now I’m talking to you and intending to keep this conversation private from others, and hope you do too”
  • Example of extremely flat org structure: Benchmark has six partners who are equal in every way (e.g., compensation, power, influence over decisions) and no associates or other lower level investment professionals. See also: Matt Cohler explains why they even cut back their website.
  • If VCs were really good managers [of their own firm], they would be entrepreneurs
  • Christopher Rust, “The Role of Human Capital Assessment (HCA) in Venture Capital Due Diligence,” Master’s Thesis (and accompanying spreadsheets) for the Engineering Management College of Engineering and Applied Science, University of Colorado, Boulder, November 2003.

Other:

  • GREAT slide on overlaid payouts from entrepreneur’s perspective
  • Things that agitate an entrepreneur in term sheets
    • Obvious ones: limiting payouts, control, making it easier to remove founders
    • Some others (ex Anti-dilution – matters only on down rounds) makes more sense to be renegotiated later as needed, rather than being a roadblock in the beginning
  • Mandatory conversion is more beneficial for entrepreneurs because it simplifies capital structure (IPOs work better with all-common stock), avoids VC-side holdups of exit, and aligns conversion point between different VCs.
  • Stages of financing (tranches) in the same round (based on milestones: product completion, key hires, revenue target) are used in <20% term sheets
  • Variations in handling an unvested part of founder’s options on leaving: disappears (everyone’s share % goes up proportionally), is strategically re-allocated to VC, given to employee pool for replacement hire (?)

STRAMGT 354: Entrepreneurship & Venture Capital (Wendell)

Unfortunately can not publish my notes from (fantastic) class discussions – there is a no-blogging policy to protect honest conversations and especially the guests.

Classes this week featured Eric Schmidt and Raymond Nasr.

Reading: Lend Me Your Ears: Great Speeches in History (Safire)

  • Pages 19-23 on Google Books
  • When tempted to use a quote just to show erudition, consider if you should have just “stolen” the underlying idea and made the point yourself, more forcefully, in some novel way?
  • “Never give me a naked quote. Put it in a little story.” – Nixon
  • Churchill facing a sloppy dessert: “Take away this pudding; it has no theme!”
  • “When Pericles speaks, the people say: ‘How well he speaks.’ But when Demosthenes speaks, people say: ‘Let us march!'” – Pericles
  • “Undeliverable” is a great example of an undeliverable word, a tripword. Embrace the thin word; eschew the fat.

Pitching tips:

  • Data slides are not about the data, but the meaning – presenter needs to lift the meaning from the data (Nancy Duarte)
  • Foreshadowing: a little lead-in story to raise curiosity before clicking to the next side
  • Eye contact is important, but the powerful presence comes from shoulder orientation, turning to the entire audience
  • Rational persuasion path: “if you accept A and accept B, you have to accept C”
  • Use the B-key – killing the image on screen immediately draws full attention to speaker. Not every thought needs a slide.
  • Kawasaki’s 10-20-30 rule: 10 slides, 20 minutes, 30pt font size the least. 30 is the age of the oldest person in the room / 2.
  • The more visual your slides, the longer their reusability
  • 19th century infographic map of Napoleon’s army failing under Moscow
  • Whenever you say “in summary” or “in conclusion”, the audience will stay with you for 45 seconds
  • When coaching a non-dynamic team member to be more alive when presentation – take some hobby of them, something they are passionate about, find a metaphor and back into the topic through that
  • Your pitch needs to reduce the number of places where investors, press, anyone can say “yeah… but”

Case: Milliway Capital (Lerder, Hardymon 2011)

  • A well compiled case of managing your portfolio through the 2008 credit crisis (compiled on 4 real VC firms and companies, with names changed)
  • There is a difference of lack of detailed due diligence and lack of any coherent hypothesis
  • In Private Equity there is usually 1-2 main partners and everyone else works for them. In California VC there are so many different VC org models you need to take time to understand the dynamic – especially as leadership only matters in tough times.
  • When you recognise the imperfection of your approach, you better allocate some reserves
  • When managing the macro crisis, explain the problem to portfolio companies and ask them to come with solutions. Either they come with better what you could have, or they come with ignorance – which is telling too.

MKTG 249 : Re-Imaging Marketing: The Power of Stories (Aaker)

Guest: Dennis Carter (creator of Intel Inside brand)

  • engineer, technical assistant to Andy Grove before getting into marketing at Intel
  • Get new products on the market and move on, don’t linger until the last success becomes a fight in commodity market.
  • Intel tried enter a “large volume integrated circuit market” by acquiring Microma, a small electronic watch maker. After its consumer marketing failure, Gordon Moore used one as his “$10M dollar watch” to move things along in meetings.
  • 286->386 campaign (on Google Books)
  • Intel Inside proposal created over the weekend, after the X86 trademark case lost in court on Thursday (can’t protect a “part name”)
  • 3% of revenues into co-op fund to help OEM partners with print advertising products with Intel Inside. Inspired by consumer co-marketing setups (P&G working with grocery stores).
    • As one side-effect, shifted the audience again, with Intel sales people getting access to OEM marketing people to build further relationships.
    • Computer magazine sales force educating OEMs they should go to Intel to get 50% support on their print ads (that they will in turn pay to the mags)
  • Goals of ingredient branding
    • Positioning the processor as important
    • Convince OEMs to identify systems that contain Intel
    • Create end-user pull for latest Intel proc
  • Competitors are not (just) other microprocessor makers, but anyone who collides with these goals – software makers, hard drives, whatnot
  • Power users and IT influencers watching late night re-runs of StarTrek – very cheap media to buy!
  • Audible pong (“the Intel sound”) created because with print -> TV shift, just having the logo on screen in someone else’s TV ad was too brief
  • More than a million of “Intel Inside” stickers distributed – showing up everywhere, like bikes in Asia (look at startup stickers now)

Guests: Don Hoang (Klout) & Marshall Porter (Gilt); Maria Amundson & TJ Kelly (Edelman)

  • Starbucks steel card (literally) launched on Gilt for $450, sold out in 11 minutes, sells on eBay now for twice the face value
  • Moms have the highest viral coefficients in the world – tight social group, often also with kids & looking for similar things in this period of their life. Every mom has a blogger to twenty they follow. But it is a very spread out network at the same time – how do you get into it at first?
  • Engaging teams: play on good ol’ Stanford FOMO – fear of missing out
  • Edelman’s Media Cloverleaf – mapping the four types of modern media, their overlaps, to help to decide where and how to begin telling your story
  • Twitter: 90% of engagement happens in first 1 hour, Facebook: 93% of engagement happens in first 3 hours. Great creative doesn’t really matter if you get the timing wrong.
  • Adobe’s CREATE Manifesto 2012 and a Global Creativity Gap info graphic
  • A hidden plus of infographics is that no media channel (traditional, hybrid or digital) wants to write the same story as everybody else. With an infographic you can give them a whole set of different angles to enter your story.
  • For B2B companies – C-suite of Fortune1000 is still reading papers and watching CNBC. Going full social doesn’t make sense yet
  • Don’t lose your Marketing 101 skills when you’re getting into social channels

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For more posts on the Stanford GSB Sloan life – see the table of contents here.