31 min read

Weeks 28-29: Bootstrapping, Europe(?!), Options & Private Equity Operators

Stanford GSB Sloan Study Notes, Weeks 8-9 (28-29), Winter quarter

So there: it takes about 28 weeks in Stanford to finally have someone mention Europe in any other context than a semi-joke about Greek macro environment in the short term. And these two weeks suddenly opened the floodgates: there was the first European company case this far, we spent some time on the (quite miserable) comparative venture financing stats between the continents and – most importantly – the rotationally geography-themed Sloan TGIF parties finally turned to the European night (affectionately dubbed as the “Estonia & the Rest of Europe” evening). Relieved with a sigh with my Swedish, Dutch, German, Swiss, French, Italian etc classmates: we have not entirely disappeared from the world map as seen from the West Coast yet, and will keep working on that threat.

Partially supported by the annual Stanford Entrepreneurship Week, the last weeks were super-exciting for the flow of external speakers – there is a separate post summarising those you should not miss. And we did do the Final View presentations of the LOWKeynotes program, including your’s truly’s 9 minutes on how hard it has been to adjust to somewhat surprisingly lacking digital living infrastructure here, coming from Estonia – videos for which will be online in 1-2 weeks. Stay tuned.

Covered in this issue:

  • Bootstrapping, venture debt and swimming against the tide in Europe
  • Exit planning and IPOs in venture deals
  • Thinking like a limited partner, structuring PE deals, operational turnarounds and the visible future of Private Equity
  • Derivatives and options – both financial and real
  • Academic research on VC compensation and incentives
  • Guests from: The Foundry, Avik Ventures, AngelList, Astia, Makena Capital, TPG, TSG Consumer Partners, Sierra Ventures, YouTube, Trulia, OpenLane, Fayez Sarofim, Accel, Meritech Venture Partners…

FINANCE 373: Entrepreneurial Finance (Korteweg)

Guests: Hanson Glifford (The Foundry, medical devices incubator), Sharon Knight (Avik Ventures, healtcare angel), Kevin Laws (COO AngelList), Sharon Vosmek (CEO Astia, non-profit focused on women-led ventures)

  • The “should you go and work for a larger company before creating a startup in that space” dilemma. More important in places like healthcare/medical (learn about regulatory and environment, etc), less so in consumer internet (the cycles so fast that if you’re thinking about an idea and haven’t started a company yet, you’re too late). Data shows that average age of growth company founders is 38 for men & 40 for women, this presumes some good cycles in many cases.
  • As an angel you have to have a checklist of what’s important for you. I’ve slipped with a a great salesman CEO and the investment where I missed my list turned bad.
  • Bad scenario with uncapped notes: company is doing fine, you’re the first money in and then there are founder issues before the A-round. While they sort them our (1.5 years!), the company keeps growing fine. Now they are raising a round at 20M and you, as the first money in, get 10% discount of that price.
  • By the time you as an early investor understand the founder is bad, the entire world already sees it. If you are an angel, just drop it and never look back – you’re not in a position to replace a CEO, etc. Not even worth the back and forth – if they are not executing on their own milestones, why would they execute on your conversation about it? Biggest mistake is to spend time with the failures.
  • Get to know other angels in the company before you actually need to sort out through tough issues.
  • The only pivot that counts is the one that is based on customer feedback. So can you really pivot before the milestones that take the product (or a prototype of it) in the hands of users?
  • In consumer internet you ignore your board before you have anything successful to talk about. Users are always several steps ahead of any board.
  • Financed startups on AngelList – what matters (based on crunching data – but AngelList only has 2 years, not the real 7-8 y you would need):
    • Relationships – and not directly to investors, but more to the “ecosystem of the battlefield” (Google, Facebook, etc if you’re in social web)
    • Tractions
    • Who their investors are – high profile investor leads to instant round raise
    • Schools matter, past titles not
    • What they do, sector, etc matters much less
  • Astia data shows there are “queen maker” angels in their ecosystem (a dozen over 14 years) – if they touch a company, there will be an exit in 2 years. Looking at deal data, nothing pre-investment really matters, post-investment activities do. Even before the crowd funding trend there have always been companies who have raised from non-savvy investors, and that has negative correlation with their success (no non-money help from investors).
  • In medical, you can’t go after incremental improvements. Far too risky as ventures, because the regulator can turn them down even if they are successful in what they do… but just not enough more than current solutions.
  • In the crowd funding arena, people get confused with Kickstarter. They to pre-sales of products that don’t exist, and have explicitly distanced themselves from crowd funding equity (in the JOBS act context).
  • Early seed investments are for operators who love that stage of the business, building these companies. There is still a “we” at the launch party, you don’t feel as distant from getting the product out as a full time VC partner. Money is a surprise you occasionally get back from some of your investments that lets you do more what you’re doing.
  • The changing seed investment landscape is changing what used to be a bundle a VC sold to their LPs. You can now get deal flow, advice, etc as separate components and cheaper. Until this doesn’t get sorted for VCs, the relationships with LPs continues to deteriorate. There are a few top names who are fine (can move fast on the few top deals that matter), but expect the industry to still contract 30%. Entire US VC volume is 0.5% of Blackrock’s assets – at some point LPs get tired around arguing why the performance is not there.
  • Corporate VCs invested 900X more money last year than top VC firms – they are not as good as it, but there is a lot of capital moving.
  • Easy access to seed capital creates walking dead: companies that should be dead, but no-one tells them to shut down (who would want to be the person who told that to Google?). Angels are probably more honest with this early feedback: not writing a check is valuable market feedback, not making referrals is a HUGE signal (it would be so much cheaper than money – why doesn’t that person do it?). This can also be a downside of some incubation programs: if you get the first check for participation (not as market feedback; and at high price), if could be misleading to the founder about where they are.
  • E-BOOK: Pitching Hacks by Venture Hacks
  • Be confident enough to challenge your own pitch.

Topic: Venture Debt Financing

Case: Avid Radiopharmaceuticals & Lighthouse Capital Partners

  • When discussing ~2008 cases, start reminding yourself of context again with The Seqoia Deck
  • Venture debt’s benefit is cash without giving up equity – makes sense when close to hitting milestones which would increase the valuation.
  • Available to pre-revenue firms, as lender expects paybacks from next venture rounds.
  • Venture debt characteristics:
    • takes smaller ownership stakes than equity of convertible notes. Typical: 10% warrant coverage on $5M loan converts to $500k of equity. More modest exit upside beyond interest.
    • more attention to timing of cash: typically ~3 year term, with some initial payout + a window where company can decide when to call the capital. For example, if you’re forced to take too much out (and start paying interests) before you actually need cash, the real cost of capital can jump up heavily from the quoted interest rate.
    • is the loan really there when you need it? more like a credit line which could be cancelled by the lender, for example if they fail with the capital calls from their LPs in macro crisis.
  • Venture lenders investment criteria:
    • VCs involved, their commitment level – are the investors going to pour in more money in next 3 years, presuming hitting milestones?
    • Timing – rather earlier, not right before the exit. The risk of getting your money back is much lower if you lend right after an equity round – the company has cash. If you lend right before the closing of next round, you still get your warrants priced from previous round – but all in all the principal+interest risks outweigh the warrant return “gravy” in decisionmaking.
    • Team and track record
    • Assets (if any). In some industries IP could be an attractive collateral for venture debt… yet, if the company defaults it could indicate that the underlying IP (and opportunities to licence it later) are less valuable than expected.
  • Annualized biotech stock volatility in 2008: 100%/year

Topic: Bootstrapping

Case: CSN Stores

  • Bootstrapping term commonly thought as coming from Baron Münchausen stories… but he pulled himself out by the wig tail. Business models that make bootstrapping feasible:
    • short development cycle
    • few employees (low salary base)
    • bargaining power with suppliers
    • trade credits and credit cards used in the system
    • few assets, low capex
    • use free stuff (guerrilla marketing, etc)
    • scalability – can you start small and grow organically?
  • Cash-to-Cash Cycle (CCC): amount of time it takes paying out cash to suppliers and collecting from customers. Inventory days + Accounts Receivable days – Accounts Payable days. Long CCC requires having large cash balances to pay salaries, rent, etc.
    • Note that in software industry inventory is zero.
    • Large transaction size exacerbates the CCC problem.

Topic: Venture financing in Europe

Case: inge watertechnologies GmbH

  • German Mittelstand companies: $3m firms, employing 70% of workforce (similar size employs ~50% in US). Many remain small, but dominate their respective niches globally: Haribo, Würth, Stihl, Brita
  • Illustration to Mittelstand mindset: top engineering graduates join BMW, Porsche, Daimler, Audi – or their suppliers like Siemens and Bosch. How far down the list would you have to go to find Chrysler, Ford, GM among the preferences of top Harvard, Stanford, MIT grads?
  • Venture Capital investments in 2008, as % of GDP: US 0.202%, EU 0.053% (UK/Scandinavia/Ireland ~0.09%, Greece/Italy/Poland ~0.013%)
  • Comparison of VC activity, US vs Germany 2011:
    • Population: 310M vs 81 (4X diff)
    • GDP: $14T vs $3.3T (3X diff)
    • VC funds raised 2006-10: 1045 vs 55 (19X)
    • Number of independent >$100 VC funds: 227 vs 4 (57X)
    • Unique startups receiving investment 2006-10: 8532 vs 772 (11X)
    • Median investment over 4 rounds of funding: $30M vs $8M (4X)
  • IPOs 1988-95: US 5500, UK 1000, DE 151. Newly listed German firm 4X+ older than in UK (side-impact of this: the few VC funds are still running 10 year funds, which means they tend to run out of time more often). Things were only briefly better with Neuer Markt, 1997…2000 internet bubble
  • Water is a $500B market globally, filtration about $50B of it. Just 2.5% of global resources are fresh water, and of that 70% is frozen.

Topic: exit logic and IPOs

  • Exit timing: Bernard Baruch: “I made all my money by selling too early”
  • Harvesting options for founder (as opposed to full exit): increase personal consumption, use debt capacity for other entrepreneurial ventures, sell to employees through gradual programs, MBO, mergers, strategic alliances with buyout downstream
  • Share-based M&A has tax benefits (taxable moment is not the switch of shares, but the eventual sale moment), but cash is still king
  • Post-IPO pro: you are still retaining control of the strategic direction (compared to a full sale) for a visible future. Even more, your large VC owners get diluted and replaced by a more amorphous public owners group.
  • In US, you have to start filing public reports when you have 500+ employees and >$10M assets, no matter if your shares are traded publicly or not. Facebook ran into this (with old-time employees selling on secondary markets and bringing new investors count up). At some point made a deal with Goldman Sachs who grouped investors together and proxies them as one – annoyed SEC.
    • Europe doesn’t have this threshold & related enforcements. And for a large part because it is much easier to get financial data on private companies (mandatory annual reports, etc)
  • The IPO banker fees are dominantly 7% and non-negotiable. Facebook-kind of large exceptions are very rare. But there is a less obvious negotiable price component, like the volume of green shoe shares available for underwriters (typically ~15% of all shares sold).
  • The first-day “pop” in price is basically extra value that company should have absorbed, but couldn’t hit with their pricing – and someone else picks it up by arbitrage (immediate sale or “flipping”). Avoiding this was one of the main goals of Google’s auction model, but they still had +15% pop. The safer workaround is just keeping the first offering minimal (10-15% of shares) and doing secondary offerings when the price has already stabilised on the market.
  • Issues with IPO price benchmarking:
    • you are comparing to other companies who have also chosen to go public. Is it really apples to apples – or are there other, more relevant benchmarks out there who have chosen to exit privately?
    • when you are trying to calculate the valuation, you likely need Asset Beta for WACC calculation. Public benchmarks usually provide the Equity Beta (higher/riskier), which you need to adjust with their leverage (debt/equity ratios) before they are useful as a benchmark.

FIN587: Private Equity (Parker)

  • Dimensions by which to distinguish between Private Equity firms:
    • backing a strong management team? or seeing as fixing/replacing it as their main tool?
    • Control: majority equity deals only? minority, with covenants?
    • Stage: Growth, Mature
    • Stability of underlying investment: from very high stability to disruptive tech plays
    • Macro perspective: seeking financial inefficiencies or betting on new insights
    • Operations: in-house teams, external consultants, intent to get involved
    • Leverage: using money from own fund mainly, or lending more from others
    • Fund size
    • Sourcing approach
  • Concentrated LP base is a huge risk. There were funds that wanted to take only Harvard, Yale, Stanford, etc money. In 2008-09 these endowments were all out of air and funds in trouble – they had chosen to ignore for example oil-rich sovereign wealth funds that were virtually untouched.
  • Very often you hear from funds that their second fund will stay the size of their successful first one (desire to not go too big to lower the bar on deals, etc). Almost never happens, $200M funds blown out of the water are always followed by a $1B raise.
  • Private Equity investment proposal in a nutshell, “Buy cheap, sell dear, and do things in between that make the spread larger”:
    • What to Buy
    • What to Pay (and Why this Will Win – why will you get it at this price): macro environment, micro evaluation, your unique angle.
    • How to Pay
    • What to Do to Increase Value (Buy cheap, sell dear and do things that make the spread larger)
      • Expenses – trim the fat
      • Leverage –
      • Cash – get rid of the excess
      • Asset sales – finance, not romance
      • Growth Strategies
    • When and How to Sell: IPO, Strategic… or can you dividend your way out of this? IPO/Strat in parallel paths makes the most money. But if there is not Strat interest right now as we’re bidding, why will there be later?
  • Buying “right” (both price AND terms, distribution of control, due diligence) is important because you can not turn it back. If you get them wrong, you are doomed for your returns.
    • Extreme negotiation illustration: “Name your price and I’ll pay it. I just set the terms.” and later “$1B you are asking for is fine. The terms are… $1 / week schedule.”
  • Ideal that few PE firms actually get to: never buy at an auction, but always sell via an auction.

Topic: Thinking like an LP

Guest: David Burke (Co-founder, Makena Capital)

  • Goals of Endowment Portfolios (from Stanford to Hewlett Foundation)
    • Payout: fund today’s generation, 5%
    • Purchasing power preservation: fund tomorrow’s generation, 3-4%
    • Real Return generation: growth of capital, 1-2%
    • Adds up to desired 10-11% returns with minimal risk
  • Makena is a fund of funds to provide a vehicle for private investors who have been looking to invest along endowments, but this would dilute the focus of university management companies too much. Most of people have come from LP side, so can relate to their needs more.
  • $16B under management, 35% from sovereign wealth, 30% family offices, 23% endowments/foundations, 12% pensions. Dozen investors make up 70% of capital. And a single family can change the LP geographical landscape (5% from Africa)
  • You can go to the best VC guys and ask if they thought Google will win and they can tell you about other things that they were as excited about, but didn’t fly. A buyout firm should be able to present a repeatable model for how they came to their winning investments.
  • Important metric: average age of assets. We’re 7 years old and currently at 33 months – every time there is a capital call you add a new zero into equation, takes a long time to get to 4-5 years average where you want to be. Old endowments are well diversified, when you build a new one – you’re sitting on cash and looking at very gradual capital calls toward the diversification you want to have.
  • There are big pension funds who say the don’t do less than $50M or $100M investments at a time. Arguably there are many exciting opportunities below that – we’ve gotten venture returns better than from Accel from one seed fund that was just $28M. If you would lock yourself too narrowly (also “wouldn’t invest more than 10% of any fund”), you would only have 2.8M at work there – would it then be worth your time?
  • Scandinavia has been providing some amazing PE returns since mid-80s. For example, Altor – niche players who only do buyouts of local family businesses.
  • Empirically, our managers are able to buy into private companies at 10-20% lower EBITDA multiples than comparable public market stocks have. Target companies have avg 16% margins (vs 19% of public peers), in 2-3 year operational work we get them to 21% on average.
  • Niches are good, performing firm with one office is better than another one with five offices.
  • Sutter Hill Ventures a good example of skin in the game – half the fund is the GPs money

Topic: Operational turnarounds

Guest: Dick Boyce (Partner at TPG)

A video of Dick talking about the TPG & PE business (unfortunately framed with rather annoying show format):

  • TPG is differentiated as “The Operator”: 100 deals in 20 years, one of the first to take on Europe. Contintental, Burger King, NeimanMarcus, Sabre, Ducati, Avaya, Petco…
  • There are segments and then there are subsegments. Take retail – after 9/11 all retail went down 15-20%, no-one shopped, no-one left their house… but then there is pet food, which was untouched.
  • TPG ops teams have a bias towards general managers, not consultants.
  • In unionised, low-retention industries (food processing) you don’t have to do massive layoffs. Find operational efficiencies and let some staff naturally churn out without replacing them. Might take 18 months instead of 2, but less motivation issues and bad press.
  • Small competitive exercises to shake up incumbent staff. Example: a team of outsiders making 180 sandwiches in an hour compared to 120 the current chef’s team with current processes. You find what’s different and roll out across the chain.
  • Big Data use case: scrape your competitors price and stock data every day. Picked up 20M in EBITDA up by increasing the margin just slightly on items other local providers had run out of stock at a given time!
  • MAC – Material Adverse Change clause: if things get crazy, we can still get out of the deal as a buyer. In reality rarely if ever works – if markets collapse, the judge will just say “stuff happens”
  • When looking comps (sales per store), always look at  multi-year period.
  • “The Bowtie” – if you plot the price increases and purchase numbers (dropping) on the same chart and they cross.
  • Operational PE needs to change the CEO very quickly. It is sometimes not even about the particular person, just giving the time, building your relationship, etc is too much risk compared to immediate change. Fear of the unknown (delaying change) is a real mistake.
  • Crispin+Porter‘s provocative ads (see videos here) supporting BurgerKing turnaround
  • Restructuring a franchise network is very work intensive. A franchisee might have 8 stores, but each of them is a separate legal entity. If you have 2500 stores in distress…
  • Misery Index to evaluate macro environment (Unemployment rate + Inflation rate)
  • Difference of operating roles at a company vs at PE firm: companies have a “romantic” overarching mission that you align your activities against. The PE mission is to make money.
  • BurgerKing trick: give all the board members a gold card (unlimited debit card at stores). In next meeting, “so, you have not been to the store in next 3 months…” – have to do it once, members either get really involved or leave.

Topic: Structuring Deals

Guest: Hadley Mullin (TSG Consumer Partners)

  • MOI (multiple on investment), alternative slang about IRR.
  • Quick & just “good” (2-3x, not 5-6x) MOI return might not make LPs happy – when you return capital early, they need to find a new place to invest it in.
  • Should you be acquiring equity or assets? (Leaving liabilities behind in latter)
  • Participating preferred stock lets the PE investors sleep best at night – max downside protection and largest share of upside.
  • Focused funds have an advantage in building relationships with the entrepreneur: they can add value on Day 1.
  • Show up to the first meeting with a company with an informed view on how they are positioned against competition: online survey of 1500 consumers on pricing, quality, etc.
  • There are cases where family owned middle market business already know what they need to do (restructure, close plants), but don’t want to be the ones doing it – personal relationships, small community, etc. Or a three-brothers-in-disagreement situation where they recognise bringing an active independent investor in will get out of deadlocks.
  • Simplest leveraged investment waterfall:
    1. Buy for $1B in equity only, EBITDA grows $100M -> $200M in 5 years, sell co for $2B (equity value) -> return on initial $1B investment 2X
    2. Buy for $1B in  $300M of equity and $700M debt, EBITDA grows $100M -> $200M in 5 years & $200M debt is paid down, sell co for $2B (equity value $1.5B after $500M remaining debt) -> return on initial $200M investment 5X
  • Debt is sweet in a growing company but turns extremely painful in any downturn.
  • With 3rd generation family owned business it is not just about “no shop” clauses to keep them not selling to others during the negotiations. Sometimes you could spend $2M on preparing a deal and someone from the family just wakes up, “grandpa wouldn’t like us selling to anyone”…

Topic: What’s New in PE

Guest: Jim Coulter (Founding Partner of TPG)

  • GSB grad ’86, Continental Airlines turnaround…

  • Used to be that the entry level jobs we had were for people from Goldman, McKinsey, etc. This year for the first time we’re hiring 2 people from undergrad (from 800 candidates), because the landscape is changing.

  • Hennessy: “you cannot really heard the cats, but you can move the cat food”

  • “Finance is the language, the starting point. I wish I took more psychology classes – every meeting is a theatre.”

  • “Watch the CFO when the CEO is talking. Like watching a wife/husband when the other side talks – if they quince, there are issues…”

  • “If capitalism had a king (which it doesn’t), it would be a French king – they pronounce you and then immediately behead you”

  • 2007 in Private Equity:

  • In the airport, don’t read the business magazines, just look at the entire stand and look what the covers tell you about the overall sentiment.

  • Celebrating Job creation: in period when FB hired 1300 (and Zuck was at the White House for that), TPG retail portfolio created 4500 and Healthcare 7500 jobs. Sentiment vs facts.

  • People want choice and control, you start with model T and you end with 23 colour options for Prius. ’95 – 23 PE funds >$1B, all of them generalists. Today 400 funds, with specialisation. 2020E 700-900 funds.

    • Our last fund was $20B, I don’t think we see another one. We might see 7 x $5B funds at the same time though, with clear focus for each.
  • Buyout is about control, different from pre-IPO growth investment, which can be very active participation, but without control.

  • Divergence of LP strategies: used to be 3-4 people in LP team. Now there are fully outsourced models (1-2 people fully outsourcing to funds of funds) and the other extreme with 15-20 people acting almost like GPs of their own (Singapore endowment, etc)

  • Interesting performance gap: if LPs expect 7% from equity and 20% from traditional PE, there is a massive gap. People are willing to put tons of money into something that delivers 12%. For example: distressed, equity-like debt: players like Oaktree Capital, Cerberus Institutional Partners, Apollo emerging.

  • In China, don’t go to Shanghai and Beijing, but to the 200 other massive cities to the east no-one has even heard of. For example: China Grand Automotive – largest car retailer in the world, 480 stores, still growing 20%+. Was just selling cars, now 60% other revenues. We put a TPG partner to CEO for 2.5 years to expand.

  • Developing market exits: buy beer, liquor, banking – and leading players from outside will eventually want to consolidate. Retail & consumer are easiest to get out of, if you can’t find a strategic buyer.

  • In emerging markets, when check sizes go >$100M there are not than many people to talk to. The natural place to start building pipeline are the emerging rich families. When you enter for the first time, the people who want to sell you controlling stakes are like the people who want to be your friends the first day when you move in high school: you don’t necessarily want to be their friends.

  • Scale enables specialisation. We have people who do nothing but search CEOs for our companies. We’ve placed 300 C-level execs in Asia in 3 years.

  • Interesting targets are those with lots of products to price. Dynamic pricing against competition can have massive returns.

  • E-procurement and vendor auctions can take 40% off prices with 10 minute exercise sometimes. We believe we can today take 10% off anything with better purchasing – giving 5% back to customers over time and keeping the rest.

  • Industry transition arbitrage: buy a paper-based player (Apartment Guide) and turn them digital. More than their absolute numbers, it matters that today markets value paper players at 6X P/E and the digital ones (Zillow, etc) at 30X. If we get anything in between, we’re good.

    • Omni-channel Economics: in clothing retail multi-channel customer is worth 4X more than stores only, and 10X than online-only customer.
  • Financial engineering as the tool of change ended in 1998. The early guys coming from Wall Street wanted to touch nothing by the balance sheet. Occasionally it makes sense, but not the game changer any more. It is about operational improvements. You can’t raise a fund today without an operating story – LPs expect it.

  • Ops model based on retired CEOs is tricky: often the CEOs have retired for a reason, and no CEO actually likes another CEO showing up to their turf. And just consultants do not get any respect. So the sweet spot is more of a “COO model” whom you send in and vertical domain experts.

  • As LPs become more sophisticated, Funds of funds are going out of business. At least the days where they charge 1-10 on top of the 2-20 of the funds they invest in are over. Yet, whoever figures out a way for individual investors to get into the best performing asset class is much needed.

  • Many people businesses have gone public (ad agencies, boutique banks) – why do others seem impossible? For ex CAA

  • When people say they don’t do an auction, think about it: we are buying decent companies. Only a stupid person wouldn’t call 1-2 other people to see if they would pay less or more than your bid. And you rarely see stupid people owning decent companies.

FINANCE 229: Sloan: Core Finance (Strebulaev)

  • “I requires a very unusual mind to undertake the analysis of the obvious” – Alfred North Whitehead. He has also said something about what can be put into a textbook is “dead knowledge”
  • Three types of financial ratios that are useful:
    • Liquidity (Current ratio, Quick ratio, Average collection period, inventory turnover)
    • Debt (Debt / Equity, Leverage, Average payable period, Interest coverage)
    • Profitability (Gross margin, Net margin)
  • When your average payable period grows too large (40->60->75 days in case) the main penalty you’re facing is not a contractual fine, but the broken relationship with suppliers. They will stop selling to you first in case of recession and you have no bargaining power.
  • Interest coverage ratio (how many times more than your interest you earn: EBITDA / Interest) can be a very misleading indicator:
    • Trade credit is also a kind of debt, but not reflected in Interest payments in P&L – and not in this ratio! And again (from last week), the interest cost of trade credit, annualised is 38-45%.
    • Interest also doesn’t include the principal (even for bank loans, but also trade credits, etc), and doesn’t show what would happen if that is called. (And banks might call them during tighter times)
  • Inventory turnover ratio overstates the turnover in case of high growth companies (as it takes the inventory as of year end as an input, but the inventory grows throughout the year). Can be misleading if you are comparing a rare, fast growing new entrant to more mature peer group.
  • When forecasting funding needs, two potential approaches:
    • project the cash flows or
    • forecast the change in balance sheet lines. Growth in accounts receivable, inventory, assets, etc – are something that you need to finance somehow, either using the cash you have, debt, etc.
      • Ratio of growth in Accounts payables to Total assets (w/o cash) will show you how much of your growth are you financing from trade credit.
      • Deficit = – ∂ Total assets + ∂ Acc Payable + ∂ Accruals + ∂ Retained Earnings
  • Chasing the top line growth blindly is a dangerous strategy unless you have a lot of cash. Being successful is financially dangerous, not just the usually recognised issues of org growth, culture change, etc.


  • Two main types of derivatives: price fixing (lock a price or rate in advance: forwards, futures, swaps) & price insurance (protect from drop or rise in price or rate: call, put, exotic options).
  • Derivatives are a zero sum game between buyer & seller. Risk does not disappear, just transfers to another participant. In a multi-party transaction, both buyer and seller could remove risk – but it will be loaded on the bank or other third party.
  • Hedging does not add value in perfect markets. Thus, it is important to know which exact imperfection you’re hedging against.
  • In a two-scenario situation (50% chance of +$5M, 50% of -$2M), hedging increases value (NPV) by moving cash flows from the good state of the world to bad state of the world, keeping the probabilities constant.
  • Hedging strategies:
    • Real investments: keep revenues and costs in same region/currency
    • Forwards: fix the terms of a transaction ahead (obligation!)
    • Options: agree on the right to do a transaction at agreed terms in future
  • Cool derivates-based intuition (and pricing model) for corporate debt & equity:
    • Corporate equity is a long position in Call option on the value of the firm.
    • Corporate debt is a short position in Put option + risk-free debt.
  • How to remember convex & concave: latter has CAVE [door shape]

Options Pricing

  • Put-Call Parity (discovered in 1960s): (Buy Stock) + (Buy Put) = (Buy Call) + (Buy TBills). For European options of  dividend paying stocks: S + P = C + PV(K) + PV(Div).
  • Asian options pay on the average price between now and exercise date.
  • Actual probabilities of underlying stocks going up or down do not matter in pricing derivatives. (But, these probabilies are embedded in pricing stock prices themselves). This was the real contribution of Black-Scholes in 1973, the basic formulas with the attempt to predict stock directions were used before.
    • Since 70s there have been 2 massive developments to progress on top of B-S: stochastic volatility and growth in computing power.
  • Delta is the sensitivity of the option, per $1 change in the underlying asset, how much does the option price change. Positive for calls, negative for puts.
  • Approaching infinite number of decision points, binomial option pricing model will converge towards the answer you get from Black-Scholes model.

Real Options

  • Delay in real options is valuable when you can learn something (acquire more information about the future options)
  • Venture capital fund is a real options portfolio. Value from the diversification (lower volatility) and exercise timings.
  • Uncertainty is not information asymmetry. Uncertainty is when nobody knows. Option value goes up when uncertainty grows, and down when asymmetry grows.
  • Practical use of real options: mining, pharmaceuticals (many clear stages which can remove a lot of uncertainty). In others, like telecom spectrum auctions, many other variables can reduce their practical value (for example strategical implications of many players able to exercise the same options).
    • Emerging ideas: bulk purchases of sequel rights for movies, books
  • “There are three kinds of economists: those who can count and those who can’t”
  • When using Black-Scholes on real options
    • T (expiration date) is the moment when the uncertainty is removed, not when you actually are planning to exercise the option
    • Sigma (volatility) = standard deviation of one year return (hard to estimate, very sensitive around the middle, but flattens out quickly, giving you quite a solid range of option value)
    • S (underlying asset price) = present value of inflows at t=0
    • K (strike price) = present value of cost at t=T
  • Incentives are dynamic: how does the moral hazard change over the duration of the contract?

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.

Case: MakeMyTrip

Guest: Tim Guleri (Sierra Ventures)

Case: YouTube

Guests: Steve Chen & Chad Hurley (co-founders, YouTube)

FINANCE 385: Angel & VC Investments (Strebulaev)

  • Sunk cost fallacy in and endowment effect in VC investing: negative NPV bridge loans to a failing startups in an attempt to save your investment into it. Can mitigate by having multiple partners per fund, delegating and rotating decision making.
  • 87% of Stanford undergraduates believe they are in the top 2 quartiles in their class.
  • Some VCs have an explicit policy that they don’t allow their GPs to be on public company boards at all. Enforces quick exits after IPO.
  • While raising their next fund, GPs sometimes convince a selected LP to front their next 1-2 investments meanwhile, to not stall until full next fund is together. In this setup LPs can get terms very close direct investment (very little if any carry, etc)
  • Three academic studies on VC Limited Partner agreements:
  • Nuances of VC compensation:
    • If the LP pays 2% management fee to VC, then in present value it adds up to 16-17% of all committed capital over 10 years, and only 9-12% if measured on managed capital. Smallprint matters.
    • Very rare to have hurdle rates on performance fees at all (standard in PE & hedge funds – either fixed 8% or benchmark like S&P500).
    • Mark to market not used in VC – whereas hedge funds take carry every quarter/year, VC general partners vest longer and get carry after LPs. More beneficial for LPs than PE/HF.
    • Net asset value based carry calculations can create a situation where VCs are paid carry for the value of not-exited investments, and should the later exits be unprofitable, they could end up returning some carry to LPs. Which is beneficial to GPs, because they effectively get an interest-free loan from LPs.
    • The present value of GP carry payouts can vary by several percentage points in IRR, just based on the payout rule of exactly the same sums: returns first rule, fair value test rule, net asset value rule.

Case: Trulia

Guests: Pete Flint (Co-Founder, Trulia), Greg Waldorf (Fayez Sarofim), Theresia Gouw (Accel)

  • Pete and co-founder Sami Inkinen met at GSB
  • As a founder, need to separate passion for the business from the rational economics to have a productive discussion about an exit with your board. You can talk to your mentors and friends for hours and hours as emotionally as you want, but when you go into the board room you should have the facts and analysis.
    • When you are already at the IPO gate, in retrospect you’re already at a place you know it will be good situation for everybody: the founders, employees, investors. So it is more about how to make it the best possible situation, not just good.
  • Having just one underwriter, especially not a top bank on your IPO cover is not a good sign
  • Considering M&A options against IPO, usually a big consideration is the cash vs someone else’s stock execution of the deal. Are you willing to take (and force long-term management to take) someone else’s market & macro risk?
  • As a startup it does matter with whom are you in the same fund with for your VC (either for a particular GP, or for the entire fund; like Trulia was same Accel fund as Facebook). Can change if the VC is after getting most out of your valuation, or more flexible on price if gets liquidity faster. Extreme version: you’re the first big liquidity event of someone’s first fund.
  • Very hard to hire a true public company level CFO before your board has actually decided to to an IPO.
  • When you go to a PE buyout firm you can get any headline valuation that you want.. but then the small print terms and crazy covenants still try to design them the valuation they really want.

Case: OpenLane

Guests: Peter Kelly (Founder & CEO, OpenLane), Paul Madera (investor, Meritech Capital Partners)

  • Public markets like simple, understandable stories. When you show them millions of cars going through the systems cheaper and quicker than anything else, it is easy to get and calculate around.
  • When a big chunk of your revenues comes from just a few customers and you go through a near death experience of loosing any of them – you suddenly realize that your small common stock position could be worth nothing.


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

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