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The Founding Fathers Were (Mostly) Entrepreneurs

Nearly all who signed the Declaration of Independence ran their own businesses.  The Big Names, the Renaissance Men, have familiar stories; yes.  But it is true of most of the less well known signatories as well.

founding_27397George Washington’s success as an entre- preneur recently earned him the moniker Founding CEO.  Born neither poor nor rich, with a father who died while he was just 11 years old, Washington transformed Mount Vernon “from a sleepy tobacco farm into an early industiral village.”

Ben Franklin ran several businesses and never patented a single of his many famous inventions, seeing them as gifts to the public.  An early open-source advocate?

Thomas Jefferson invented many small practical devices (e.g. the swivel chair) but, like Franklin, had no interest in commercialization.  Furthermore, if you count these sorts of things as entrepreneurial – and we do – he founded the University of Virginia and the middle part of the country known as The Louisiana Purchase.  Jefferson however (and unhelpfully) was not exactly a huge fan of finance:

The system of banking we have both equally and ever reprobated. I contemplate it as a blot left in all our constitutions, which, if not covered, will end in their destruction, which is already hit by the gamblers in corruption, and is sweeping away in its progress the fortunes and morals of our citizens.

Letter to John Taylor, 1816

Well, nobody’s perfect.  That kind of attitude is what lands you on the $2 bill.  More seriously, his view of banks seems to have reflected his distaste for public debt and inter-generational debt.  (He inherited his father-in-law’s estate and its debts, which took years to pay off and contributed to his own personal financial difficulties.)  We can imagine he would have felt differently about the type of financial backing that allowed yeoman entrepreneurs to pursue happiness.

This 2013 piece by Bill Murphy Jr. in Inc. magazine tells the stories of the less famous self-made men behind the Declaration of Independence:  “Doctors, lawyers, merchants (and a few ne’er do well heirs).”  The merchants were entrepreneurs, obviously, but even those doctors and lawyers would have had an entrepreneurial bent, typically arranging their own educations or apprenticeships, hustling up clients, and running the business end of their own practices.

We hope all our readers and their families enjoy a Happy Independence Day.

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Lost: $1 trillion

Today’s Wall Street Journal reports:  since 2005 productivity has declined 8% off its long-run trend, which has meant $1 trillion less in business output.  The reason?  Fewer start-ups.  From Behind the Productivity Plunge:  Fewer Start-ups

Lagging productivity growth is an enormous problem because virtually all of the increase in Americans’ standard of living is made possible by rising worker productivity. In our view, an important factor contributing to declining productivity growth is the large decline in the creation of new businesses. The creation rate of new businesses, as well as new plants built by existing firms, was about 30% lower in 2011 (the most recent year of data) compared with the annual average rate for the 1980s. (The data is the Census Bureau’s Business Dynamic Statistics.) The decline affected nearly all business sectors.

Steven Malanga coined the term startupicide – “suffocating regulations, inflated business taxes and fees, a lawsuit-friendly legal environment, and a political class uninterested in business concerns” – which gets sprayed on every business, large and small.  At the margins those factors clearly affect the viability of new businesses and new projects.  Here’s how we once put it, discussing just one of the four ingredients:

For Costco (one example) to build a new store, a 40% tax rate on the income will require much higher sales expectations for the store than if taxes were 30%, or 20%, or 0%.  It’s the same analysis regardless of who is making the investment decision: rich angel investor, venture capitalist, Fortune 500 CFO.  When taxes are higher, fewer stores get built and fewer companies get started.

The WSJ piece continues:

New businesses are critical for the U.S. economy to grow because a small fraction of today’s startups will become tomorrow’s economic heavyweights. Most of today’s workers are employed at older, established businesses, but the country cannot rely on existing companies to boost the economy. Businesses have a life cycle, in which even the largest and most successful reach a stage at which they stop expanding.

If history is any indication, many of today’s economic heavyweights will ultimately decline as new businesses take their place. Research by the Kaufman Foundation shows that only about half of the 1995 Fortune 500 firms remained on the list in 2010.

That’s the funny thing about those large companies:  they all have birthdays, either as start-ups themselves or as spin-offs from other companies (who were once start-ups).  Many of them are born during very bad times – as long as the entrepreneurial incentives, and entrepreneurial optimism, remain intact.

Over half the companies on the Fortune 500 were started during a recession or bear market.  The patents for the Television, Jukebox, and Nylon were granted during the greatest period of job destruction in our history:  The Great Depression.  (Although we can’t confirm any patent information on the chocolate chip cookie, it too was invented at the same time.)  This is precisely the creative destruction that makes our economy an engine of innovation and wealth creation.

That $1 trillion in forfeited economic output demonstrates that a growing economy, with plenty of opportunity, and no shortage of entrepreneurial activity (at start-ups and within firms) should not be taken for granted.

 

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Conversations about valuations

This article on valuation from the Houston Business Journal is written from the point of view of middle-market investment banking, but it’s also relevant to term sheet negotiations between entrepreneur and venture capitalist.  Higher EBITDA doesn’t automatically lead to higher multiples (and higher valuations).

The reality is that valuations are much more complex and are primarily a function of the underlying fundamentals of a business. These fundamentals might include growth opportunities, recurring revenues, customer and product diversity, entry barriers, proprietary products and high levels of free cash flow.  Our experience tells us that different buyers can have widely divergent views of value based on their relative assessments of these underlying fundamentals

It is important for private business owners to understand valuation drivers and to develop the financial and operating data that will enable buyers to properly assess the underlying fundamentals of their business.  More clarity for a buyer leads to a higher level of confidence and a more attractive valuation for the seller.

It also leads to a higher level of confidence in the relationship.  The early conversations about valuation (and control) begin to shape the personal chemistry crucial to a successful long-term partnership.  Clarity and transparency, which make it easier for everyone involved to observe how decisions are being made, are much more important to hopeful-future-teammates than either side trying to squeeze maximum value out of a single transaction.

If a good tone is set early and maintained consistently, over time everyone on the team worries less about who’s in control and more about how to create the best scoring opportunity.

Mg_ts_bd

 

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Vintage Future VI

Here is the long-overdue “VIth” installment of our Vintage Future series, in which we take a tongue-in-cheek look back at the predictions of past generations of investors and futurists.

In our line of work it’s good to guard against the hubris inherent in projecting conventional wisdom too far out into the future, and to remind ourselves that today’s trend can be tomorrow’s punchline.

Courtesy of “The Forgotten Firsts: 10 Vintage Versions of Modern Technology.

Predicting technology trends is not for the weak at heart – and that’s before one tries to protect the IP and find a way to profit from it.

These are among the reasons we affectionately call the really early stage of investing adventure capital, and consider ourselves a “growth accelerator” for established, rapidly growing businesses with strong management teams. We prefer to focus our efforts on assessing competitive and execution risk rather than product or business model risk, and we want to see tangible evidence of the unique value offered by a company’s product or service.

 

N.B. – previously featured in Vintage Future:

 

 

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How private entrepreneurs won WWII

Freedoms ForgeIn case you missed it late Friday (June 6) online at the WSJ:  How private entrepreneurs won WWII.

We appreciate the author’s (Freedom’s Forge) point that it was the entrepreneurial spirit of both the Titans of Industry and their smaller counterparts who made the Arsenal of Democracy possible.  “Big and small firms – all – stepped up.”

Easy to forget that in 1940 we had only the 18th largest military in the world, behind Argentina.

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Appreciating the rich for how they got there, Part II

We once wrote that the hard-earned success of entrepreneurs is what gives them the inclination and the wherewithal to help support the next generation of high-growth companies.  The wealth created “yesterday” is not stuffed under plump mattresses, it’s used “today” to fund the businesses and innovations that enhance and enrich all our lives.  Most of those savings come from a relatively small fraction of individuals in the top income tax bracket, and to disparage them is to bite the hand that feeds long-run economic growth.

Intel's 4004: the first microprocessor

Intel’s 4004: the first microprocessor

John Steele Gordon, author of “An Empire of Wealth: The Epic History of American Economic Power,” advances the argument in the 6/4/14 Wall Street Journalextreme leaps in innovation, like the microprocessor, bring with them staggering fortunes – but also enrich and enhance all our lives.

(N)o one is poorer because Bill Gates, Larry Ellison, et al., are so much richer. These new fortunes came into existence only because the public wanted the products and services—and lower prices—that the microprocessor made possible. Anyone who has found his way home thanks to a GPS device or has contacted a child thanks to a cellphone appreciates the awesome power of the microprocessor. All of our lives have been enhanced and enriched by the technology.

This sort of social transformation has happened many times before. Whenever a new technology comes along that greatly reduces the cost of a fundamental input to the economy, or makes possible what had previously been impossible, there has always been a flowering of great new fortunes—often far larger than those that came before. The technology opens up many new economic niches, and entrepreneurs rush to take advantage of the new opportunities.

The full-rigged ship that Europeans developed in the 15th century, for instance, was capable of reaching the far corners of the globe. Soon gold and silver were pouring into Europe from the New World, and a brisk trade with India and the East Indies sprang up. The Dutch exploited the new trade so successfully that the historian Simon Schama entitled his 1987 book on this period of Dutch history “The Embarrassment of Riches.”

Steele mentions a few other notable examples:

  • James Watt’s rotary steam engine sparked the Industrial Revolution, causing growth – and thus wealth and job creation – to sharply accelerate.
  • Railroads made transportation cheap and created national markets.  Railroad owners and retailers made fortunes while everyone benefited from easier access to cheaper goods.
  • Edwin Drake’s drilling technique made oil abundant, the Bessemer converter made steel cheap, and both taken together made the automobile possible;  this in turn had spillover effects (and fortunes) in other industries (rubber, glass, road building, etc.)

The Little Miracle Spurring Inequality today is cheap computing power.  Software, hardware, the Internet, and precise inventory control have transformed the world and created huge new fortunes in the process.

To see how fundamental the microprocessor—a dirt-cheap computer on a chip—is, do a thought experiment. Imagine it’s 1970 and someone pushes a button causing every computer in the world to stop working. The average man on the street won’t have noticed anything amiss until his bank statement failed to come in at the end of the month. Push that button today and civilization collapses in seconds. Cars don’t run, phones don’t work, the lights go out, planes can’t land or take off. That is all because the microprocessor is now found in nearly everything more complex than a pencil.

Just as before, that wealth will not be stuffed into mattresses, it will go to work:

Any attempt to tax away new fortunes in the name of preventing inequality is certain to have adverse effects on further technology creation and niche exploitation by entrepreneurs—and harm job creation as a result. The reason is one of the laws of economics: Potential reward must equal the risk or the risk won’t be taken.

And the risks in any new technology are very real in the highly competitive game that is capitalism. In 1903, 57 automobile companies opened for business in this country, hoping to exploit the new technology. Only the Ford Motor Co. survived the Darwinian struggle to succeed. As Henry Ford’s fortune grew to dazzling levels, some might have decried it, but they also should have rejoiced as he made the automobile affordable for everyman.

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Mt. Everest conquered but not tamed

hillarynorgay61 years ago, on May 29, 1953, New Zealander Edmund Hillary and Nepalese sherpa Tenzing Norgay became the first to reach the summit of Mount Everest, arriving just before noon after spending the night high on the mountain.

The anniversary brings to mind another May (1996) expedition on Everest which ended in deadly disaster.  The details of what went wrong in that May 43 years after Hillary and Norgay’s triumph are recounted by John Krakauer’s Into Thin Air (one of the recommended books on decision-making in The Library in St.Pete.)

air_In the author’s retelling, a series of events led to several climbers inexplicably ignoring the “Two O’Clock Rule,” which says:  if not at the summit by 2:00, turn back because “darkness is not your friend.”   Their descent occurred at night, in a blizzard, as they ran out of supplemental oxygen.  5 people died and others barely escaped with their lives after many hours wandering in the dark while braving subzero temperatures.

That series of events was analyzed by Professor Michael Roberto in a 2002 paper entitled “Lessons from Everest.”  It had struck Professor Roberto that “the disastrous consequences had more to do with individual cognition and group dynamics than with the tactics of mountain climbing.”  He found several factors that caused experienced people to violate their better judgment.

Cognitive biases

3 cognitive biases came into play:

  1. Sunk Cost Fallacy:  The magnitude of the personal investment – $70,000 and weeks of agony – made many reluctant to turn back once so close to the peak.  “Above 26,000 feet the line between appropriate zeal and reckless summit fever becomes grievously thin.”
  2. Overconfidence bias:  The lead guides had impressive track records of success and had overcome adverse conditions before.  One told his team, “We’ve got the Big E figured out.  We’ve got it totally wired.  These days, I’m telling you, we’ve built a Yellow Brick Road to the summit.”   He also “believe(d) 100% I’m coming back” because “I’m going to make all the right choices.”  The overconfidence extended to many other climbers as well.  Krakauer wonders if they weren’t “clinically delusional.”
  3. Recency Effect:  Paying too much attention to recent events.  Climbers had encountered good weather on the mountain in recent years so many of the climbers thought the storm was surprising but in fact it was rather typical.

Team Effectiveness

The team lacked the ‘robust social systems’ in which members’ informal  modus operandi ensure that the decision-making process functions properly.

  1. Climbers were almost strangers and had not had time to develop trusting relationships.
  2. Group members did not feel comfortable expressing dissenting views, in part because one expedition leader had stated, “I will tolerate no dissension up there… my word will be absolute law.”  (Sadly, to protect everyone via enforcement of the Two O’Clock Rule.)
  3. There was an absence of candid discussion due to (a) the deference in the “guide-client protocol” and (b) a pecking order amongst the guides that led “lesser” ones to keep their concerns to themselves.

Complex Interactions and Tight Coupling

Very briefly, “the team fell behind schedule and encountered the dangerous storm because of a complex set of interactions among a customs problem in Russia, Scott Fischer’s acclimatization routine in Nepal, a Montenegrin expedition’s use of rope, a failed negotiation with Outside magazine, and so on.”  There was also no slack in the system, so when there was a problem in one area it triggered failure in another.

The bottom line may be that they violated a sacrosanct rule, but the more interesting question is why?  The unwillingness to question team procedures and exchange ideas openly prevented the group from revising and improving their plans as conditions changed.

Though the stakes are (much) smaller in a high-growth company, an entrepreneur faces similar challenges:  he has a team and a plan, faces a fast-changing environment, and the odds might be long.  Success hinges on creating an environment of mutual accountability in which team members trust and challenge each other.

 

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Which corporate structure is best for a start-up?

business structures 2This article in Entrepreneur suggests that many entrepreneurs give insufficient thought to the corporate structure of their start-ups, that they “check (it) off their list on a weekday night after researching on the web for an hour or so.

LLCs, S-Corps, and C-Corps offer different advantages and restrictions, and choosing poorly can lead to expensive and difficult changes down the road.  There are many complexities and issues to consider and no one right answer.  You can, however, reduce the number of future headaches (and possibly legal bills) if you choose the structure that is most appropriate for both your current situation and your long-term objectives.

Aside from avoiding personal exposure to business liabilities, the main considerations when choosing from among the three structures are i) tax consequences, such as maximizing the benefit of start-up losses, avoiding double taxation, ordinary income versus capital gains treatment and state nexus issues, and ii) corporate governance issues.

C’s and LLC’s tend to dominate the landscape of venture-backed companies because an S allows only up to 100 shareholders and one class of stock, and does not allow corporations or partnerships to be shareholders.

We have invested in both C’s and LLC’s with success over the years, and wrote this White Paper on the topic to provide an unbiased perspective and help educate entrepreneurs on the benefits and potential drawbacks of each structure.

LLC or C

LLC or C – comparison table

We invite you to read the White Paper, but, very briefly:  in our experience, very few venture-backed LLCs benefit much in the area of tax avoidance and the defined governance structure of a C-corp is almost always preferable.  Moreover, the high legal costs and ambiguity associated with some Operating Agreements that accompany the LLC structure make it a potentially disadvan- tageous approach relative to the C-corp.

That being said, we have seen situations where an LLC structure makes sense for everyone involved and we discuss that with entrepreneurs when it is the case.

Think hard about your long term goals for the business when getting advice on your legal structure.  Just as people shouldn’t decide to have children for the tax benefits, we advise that you don’t view tax considerations in a vacuum when choosing the legal structure of your business.

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BPV invests in PowerDMS

logo-PowerDMSBallast Point Ventures is pleased to announce a growth equity investment in PowerDMS, a cloud-based document management software company whose platform organizes policies and procedures online, allowing companies to distribute crucial documents collaboratively, message employees and capture signatures.  Proceeds of the investment will be used to augment the company’s sales and marketing team and enhance its technology platform by offering new features to its customer base, which includes customers in law enforcement, public safety, healthcare, and retail.

Founded in 2001 by CEO Josh Brown, the robust software platform provides practical tools necessary to organize and manage crucial documents and industry standards, thereby helping organizations maintain compliance with constantly evolving industry accreditation protocols. Created as a software-as-a-service (SaaS) model, PowerDMS combines attributes of Governance and Risk Compliance (GRC) and Enterprise Content Management (ECM) into its software platform.

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NFL combine drills actually pack (some) predictive power

ESPN the Magazine asks, of the NFL Combine’s influence on the Draft, “How do you weigh a week of drills against three or four years of a player’s work?

NFL draftCiting regression analysis of combine metrics dating back to 2006, by Jeff Phillips, MIT grad and principal of the Parthenon Group, columnist Peter Keating writes:

If you look at certain combine stats, they explain on average 20 percent of how well players perform during their first three pro seasons.  That’s probably a weaker relationship than most team executives would want, but it aint zero…  Phillips found that different measures matter for different positions.  For instance, 40-yard dash time – sometimes derided by analysts who argue that players don’t actually have to run 40-yard dashes in games – is the only skill that’s significant for all positions.  A players’ weight is important for offensive linemen, defensive linemen and linebackers, while scores in the three-cone drill (which measures agility) matter for running backs and defensive backs.  Other metrics are narrower in their predictive value… definitive answers haven’t emerged yet from the fledgling research.

The data don’t predict a player’s ceiling, the “perfect storm awesomeness of Adrian Peterson or Patrick Willis.”

The raw data simply don’t know what kind of system a player will enter, or talent he’ll have around him, or luck he’ll have with injuries, or intangibles he possesses.  But (the) stats do a pretty good job of separating the potential stars from likely busts…  So looking at extreme cases from the class of 2014, Jadeveon Clowney’s 40 time was 0.3 of a second faster than any of the five best defensive linemen drafted in the past eight years, and his Phillips stats are better than 99 percent of players at his position.  Among less famous prospects, keep a draft-day eye on Brandin Cooks, a receiver from Oregon State, whose blazing speed helped him achieve the third-best blend of stats among all wideouts since 2006… [picked Rd 1, #20 by the Saints] watch Minnesota’s Ra’Shede Hageman too [picked Rd 2, #5, #37 overall by the Falcons].  Just 11 defensive linemen over 300 pounds in Phillip’s database have shown better speed than Hageman did at the combine, and eight of them have gone on to successful NFL careers.

On the flip side, Ha Ha Clinton-Dix could go in the top 10 but he was below median in every key component of Phillip’s statistics for defensive backs at this year’s combine [picked Rd 1, #21 by the Packers].

We recently made a crucial distinction in another post on the topic of data and decision-making, entitled The greatest comeback ever and the limits of decision modelssome outcomes can be influenced and some cannot.  Big data may help make accurate predictions or guide knotty optimization choices or help avoid common biases, but it doesn’t control events.  Models can predict the rainfall and days of sunshine on a given farm in central Iowa but can’t change the weather.  A top draft pick may or may not develop based on the system, surrounding talent, &etc.

In our experience the best results often come from a combination of deliberation and intuition.  Too much data can lead to analysis paralysis, common sense can be a shockingly unreliable guide, and those who rely on intuition alone tend to overestimate its effectiveness.  (They recall the times it served them well and forget the times it didn’t.)

In the wake of the last financial crisis, BoE Director of Financial Stability Andrew Haldane deployed an analogy about a Frisbee-catching dog to explain how complex (and sometimes frivolous) attempts at regulation push the limits of data modeling or even the nature of knowledge itself.  The dog can catch the Frisbee despite the complex physics involved because the dog keeps it simple:  run at a speed so that the angle of gaze to the Frisbee remains roughly constant.

So while old-fashioned intuition is not out of date it’s also unwise to rely only on one’s instincts to decide when to rely on one’s instincts.  The dog’s doing just fine, but if it involves more than a Frisbee he might want to crunch some numbers too.

Specifically about this year’s draft:  we’re never quite sure what to make of the draft, it’s so over-hyped.  Clowney seemed like the obvious first pick and Manziel is high risk, so that worked out as expected.  A pretty efficient market overall given the information available to the teams…

 

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