Week 30: Exits, Second Markets, M&A & Thunderlizards

Stanford GSB Sloan Study Notes, Week 10 (30), Winter quarter

Originally planning out March I was quite sure that next week will be a complex one, after all, it is still labelled in calendar as the “exam week”. In reality, the Winter Quarter pretty much culminated today, with the last Finance class where the entire Sloan class was together in the same lecture. We do have one more core in Spring, but it will be in sections, so between all electives and split schedules, it will be mostly social when we meet from here on.

This week was mostly about delivering papers and presentations. With one team we built a business plan and pitched a crowdsourced service for proofreading and language learning feedback to dyslexics, foreign students and white-collar immigrant workers. With another team, we designed an elaborate proposal for taking a real public company private, shifting their product portfolio for higher exit multiples, levering up the non-existant debt, restructuring operations (yup, the founder’s private jet and golf tournaments need to go) and getting out at 10X of our money in 5 years. With third group, we pre-analysed and went through 6 real startup pitches along with a real VC mentor and decided to maybe just to give money to one of them.

Despite of the chaos of trying to schedule ~20 people into these different groups at conflicting times, I really enjoyed actually doing stuff (as opposed to just discussing in class) with my MBA peers. The ease and breakneck speed at which almost anyone in this school can deliver complex quant models and high quality analysis still amazes me. And then you can pull pretty much anyone on stage with a 5 minute heads up to present the outcome with coherent, engaging story line.

I have jus two final exams this quarter, three hours of Entrepreneurial Finance (cap tables, term sheets and anti-dilution math) done last night and Core Finance (WACC, optimal portfolios, options and bonds) to be done next week. Then onto the East Coast study trip and the saddening final 10 weeks here.

Study notes covered in this issue:

  • Alternative equity markets filling the IPO gap
  • More Exit talk, especially Mergers & Acquisitions
  • Real pitches from real startups
  • Hunting for the Thunderlizards
  • Guests: Barry Silbert of SecondMarket, Peter Currie, Louis Elson from Palamon, Mike Maples of Floodgate

FINANCE 373: Entrepreneurial Finance (Korteweg)

Case: SecondMarket

Guest: Barry Silbert (Founder & CEO, SecondMarket)

  • Believe the change in public market IPOs is structural, not a few-year cycle. Today you need to be a $750M..$1B company to become and be successfully public. Whole set of reasons – SOX overhead, high-frequency trading, disappearing of medium-cap company focussed investment banks, decimalization bringing spreads down…
  • Microsoft, Google, Facebook, etc all went public in a forced timing manner, because hitting the 500 investor ceiling. JOBS Act will raise this to 2000 people, not including former and current employees.
  • Supportive of tiny crowd funding, but not getting into it.
  • Kauffman foundation’s last annual list of recommendations included a suggestion to add a “sophistication test” as a qualifier for accredited investors. $200k income / $1M assets is a very coarse way of deciding who is fit to invest in risky illiquid assets.
  • General solicitation limitations on fundraising going away. Getting into primary stock of anything used to be an old boys club, “clients of Goldman Sachs” kind of limited group.
  • Liquid second markets theoretically should lower the share of equity startups need to give their employees – because they place more value in each unit for the additional transparency.
  • Have experimented with different rules of the plan. When you allow anyone to sell everything they have have vested – it actually never happens with current employees.
  • Companies should by default lock their stock rules down in articles of association / bylaws, require explicitly to approve any sales to outside buyers. And then, from that basis, open second market up in a controlled way: “we allow new investors, no lower valuation than this, common stock only, no board seats”, etc
  • Adverse selection issue: if you are the hot startup and get money thrown at you – you are the company that needs SecondMarket’s help the least. Need to be careful to retain the quality of companies, is working with curated pre-qualifiers like AngelList and very handpicked funds.
  • It is hard to imagine a company that raises a broad based round in their seed stage and then later, at “IPO time” says “we are not going to take money from our fans and customers”. It becomes cultural.
  • Price gets set by either of the 3 ways:
    • Negotiation – by co & lead investor(s)
    • External evaluation
    • Two-sided dutch auction
  • Facebook was a massive anomaly, still creating negative ripple stories how “bad it was for dentists and doctors to buy FB at $200B”

Topic: Mergers & Acquisitions

  • March 14 was “Pi day” (3.14!)
  • M&A can be friendly, hostile, solicited (divestiture of subsidiary, distressed assets, …)
  • $500B+/year globally. DeaLogic – source for M&A data.
  • There used to be a set of M&A deals done just to accumulate net operating losses (which can be carried over and reduce taxes). Today regulators have a clear stance against that and acquirer needs to be able to present a solid business/synergies logic for a takeover.
  • Diversification is always a questionable sole M&A motive – investors should be diversifying their investments themselves, you as a single holding of their’s doing it feels random. Large corporations are more difficult to run, empire-building fallacy. But, there are thinks like avoiding costs of financial distress, debt capacity / lower borrowing cost, liquidity (if target is private) that could be enough of a financial justification.
  • Merger or Consolidation requires shareholder agreements (as both entities might cease to exist), acquisitions do usually not, especially on the target side.
  • Instead of the company, you can acquire the assets: the target remains as an empty shell, with a whole bunch of cash that you just paid and any debt left over that you did not acquire. Usually liquidated then. Asset acquisitions really can’t be hostile.
  • In recent years, share of tender offers of total deals has been growing to 30%+. Main reason is companies sitting on a lot of cash in economic turbulence – you can not offer your shares in a tender usually, but you can participate when you have cash.
  • Purchase price is a monetary value of cash and stock used as payment. Yet, as the stock price can fluctuate, the stock part is execution referred to as a share-to-share conversion rate. Because the conversion of one equity to another at market price, there is no capital gain to be taxed.
  • In practice, companies focus on if an acquisition is accretive of dilutive to their EPS. Method of payment impacts that: reducing the share component raises post-merger EPS. Still just a short-term accounting exercise.
  • Average M&A premium in closed deals is ~+25% over the share price a week before. The target, on average, gets a ~+16% bump in their stock price, so captures most value (vs acquirer’s -1%), but not the full premium.
    • Acquirer (or free riders) can take back some of that value by buying shares (up to a 5% threshold before you need to file with SEC) before taking the offer to the target.
  • Quantitative valuation: with data, DCF is the answer. Qualitative valuation: without data, what is the question?
  • Looking into VC industry future, you can see some discussion of varied fees and commitment levels (e.g LPs with 5 year commitment pay more than 10y ones). Already happens in  hedge funds.

FIN587: Private Equity (Parker)

Topic: Exiting Private Equity

Guests: Peter Currie (Currie Capital; ex-CFO Netscape; GSB’82), Louis Elson (Founder, Palamon Capital Partners)

2009 article on Currie’s involvement in Netscape & Facebook: Meet Peter Currie, Facebook’s New Money Man (For Now)

  • Venture firms typically distribute stock back to LPs, PE dominantly cash. One reason is that if the stock was split into smaller LP chunks, it would lose part of it’s value as a whole holding, the “control premium”
  • Terminal value calculation in PE investments is not just hypothetical speculation, you actually need to materialise that. You just don’t know the timing.
  • IPO is usually not really in exit. It raises primary capital for the company, but takes a long time for the PE to still get out a full exit for their capital. More IPO issues:
    • Trading windows open and close, drives you crazy.
    • The probabilities are against you. Say you have a company with potential to meet 90% of your expectations – sounds great. Yet, this would mean that you have, say, 50% chance of missing a single quarter in first 2 years after IPO. Due to market psychology, it is never guaranteed that stock goes up when you make a quarter, but it is guaranteed the stock goes down when you miss one. Due to lockups and windows, this makes it quite sure that the PE investor will not get to the full exit without that drop.
  • Mergers are usually not an exit (if it is a stock swap).
  • In PE you would not be able to manage your LPs differently from each other – but in public company merger, a mixed shares+cash deal could be agreed between shareholders, who gets stock and who gets cash.
  • Two best times to exit: when you can or when you have to. Will you wait until you’ve “chewed all the sugar out of the gum,” and how would you know?
  • Funds are raised for 10 years, but average life today is 17 years. Extensions, one year at a time, require explicit LP permission. LP-s in the world are not staffed to own underlaying investments directly – so if they agree the time is not right to exit something in portfolio, they will agree to extend.
  • Exit planning before going into a deal is very necessary even if just for getting the team on the same page – not enough if you have “some vision” in your head.
  • Palamon using Monte Carlo simulations to predict exit parameters: recognising that you don’t know with enough confidence. For example an online business: applied on user traction, order volumes, additional financing, exit multiples… “You’ll know they are wrong in the middle – and right at the ends”. And on top of that you can run tornado analysis to determine which elements matter most.
    • Forces conversations about real operational inputs, not the bottom line IRR. The input levers you can really impact, not the single output metric you know is wrong (just a guess).
  • Selling to corporate buyers takes time, pre-marketing and independent (non-PE partner) middlemen who can do viable, “exclusive” intros through the CEO network in the given industry. Intermediaries also help to avoid seller looking desperate. Keep distance.
  • “Every company gets sold, not bought!” – the trick of great salesmanship is that the buyer thinks it was the opposite.
  • Financial buyers are much faster than corporates, they are culturally deal-focused and motivated, but need to be very carefully managed.
  • A good mix of both corporate and financial buyers helps to balance each-others curiosities. Just make sure (with careful signalling) that they know about each other breathing on their neck.
  • 10% of auctions are 1 bidder, 60% with 2. It doesn’t need to be broad, it needs to feel competitive.
  • Founders who have hit their ceiling in growing alone are “caged lions” – you can even see them pacing back and forth in meetings!
  • Europe: a lot of change towards federalisation going on underneath a low-growth umbrella.
    • 43 of top 100 companies globally are in Europe.

FINANCE 229: Sloan: Core Finance (Strebulaev)

  • Diligence is the mother of good luck. (American proverb)
  • Difference in A & B share values in US market are 2-3% (mostly for voting rights), in Italy 20%+ as the preferred shareholders are abusing their power more.
  • Pyramidal, hierarchical ownership structures, common in Asia, produce a chain of ownerships where A owns 51% of B who owns 51% in C who owns… Eventually there could be a 0.1% ownership in some company in the end of the chain, where A still has virtually full decision making control.
  • Investment in Iridium satellite communications was $12B in 90s, recovery rate about $30M. Satellites need to be replaced in 7-year cycles, out of the debt they issued, about $7B was short-term debt. When Russian, Asian crises hit, those loans blew up. If you leave incompetence aside, bankers (not banks as institutions) are incentivised to force 1-year loans to get more frequent initiation fees.
  • Evidence shows that young analysts are more likely to give controversial correct predictions. Little to lose (no reputation built up yet) and a lot to win, especially if you stand out from the general opinion.
  • NPV, WACC, etc all think about averages of cash flows, real options allow you to think about the distributions of cash flows.

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.

We concluded the year with pitches of all 17 business plans student teams pulled together during the quarter (and S354 is famous for this feature – after all, with eBay original funding done based on MBA-s work in this very class). Again, can’t share much per class agreement, but I guess it is OK if I just link to the sites of the startups who don’t just have a business plan now, but are already live with their product/service:

FINANCE 385: Angel & VC Investments (Strebulaev)

Topic: 6 real startup pitches + an enactment of a partners meeting to decide investments

  • If the entrepreneur’s estimate on their valuation or round size are off the charts, it doesn’t mean the end of conversation necessarily. Often it is just a sign that there is difference in opinion of what and when the next feasible milestone should be before the next rise.
  • Many intelligent people get into trouble in venture because they fall in love with a series of elements of a deal and then convince themselves “I can fix that one last thing”. It is hard to change, to go from $10M expectation to happy $4M valuation team or change one of “two CTOs” in a founding team into a great CEO.
  • Revisiting successful deal’s partner meetings in retrospect you see there was almost always at least one partner against it.
  • Don’t ask how much money to put in, ask who of the partners wants to live with it for 5 years.

FounderSoup

http://foundersoup.com/

Guest: Mike Maples Jr (Floodgate)

  • You need four skills on the core team, in roughly equal presence and aggressiveness: tech vision, tech execution, business vision, business execution. Doesn’t have to be four people, but some combinations are more likely in a single person than others.
  • It takes more money to fund a crappy company than a great one. Today, ask yourself, can you disrupt the world for 5 million dollars?
  • Need mentality to be different, not better. Too much mindless competition. Different is believable and memorable. That doesn’t mean everybody has to like you, but that the people who like you are truly passionate.
  • Feels there can be something like too much product centricity. The Lean Startup and Customer Development stuff is great, but these books don’t tell you how to build the culture you want in your organisation, run a staff meeting, a board meeting – these other things that an entrepreneur needs to learn how to do. Besides product builders, you need company builders to be success over the long term.
  • Cultural questions a startup should ask: do you focus on getting the right answer or that everybody feels good after this process? Do you value meritocracy or team based bonuses – can’t have both. If you get sued for poaching, do you continue because you declared getting the best talent is your #1 goal?
    • Rarely a cultural statement is something that does not give up something else great!
  • What do CEOs do accidentally that create politics? Ben wrote about this: for example, giving an ad hoc raise to someone who threatens to leave.
  • Instead of positioning against competition, startups should spend time on category definition.
  • Tracking and following tech trends is like an art appreciation class instead of creating art. Most great entrepreneurs build on an unique insight that comes from within.
  • Part of the Stanford miracle is the flow of the amazing founders walking through (I had McNealy, Osborne, Jobs…) – you sit there as a student and you say, hey, these guys are not that much smarter than me – I could do this as well. This is almost impossible to disrupt in any other location in foreseeable future.
  • Niche ecommerce: http://www.modcloth.com/ – less than $1M investment to get to similar level of monthly revenue.
  • Y-combinator video interviews (by Loopt founder) of 60 founders saying how they choose who to take money from: perceived mojo
  • If you are with the company at the death bed, when the chips are down – you get more positive word of mouth than you would believe as an investor.

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