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ESPN reported that Chris Borland is retiring after one year, giving up over $500,000 in salary, citing head injuries as the primary concern.
The NFL may be a non-profit, but its member teams are all businesses. It makes me think of one of the shortcomings of business. Normally I would argue that business is the principal framework for societal good. A business like the NFL provides entertainment. NFL team employees earn a living delivering this entertainment. NFL customers pay to participate in football through tickets, apparel, and consumption of ads. Two independent parties looking out for their own best interest are achieving something wonderful. That’s business at its best.
But what would happen if the NFL realized it needed to stop? What if they couldn’t get ahead of chronic traumatic encephalopathy and decided, for the health of their players, as a moral decision, just to stop what they were doing? They couldn’t. Every bit of value tied to the NFL has been based on the assumption of an infinite time horizon. “The NFL will continue indefinitely.” The values of all the teams and all the players and all the marketing are all inflated beyond what any finite business is worth. This is the case for most businesses. Livelihoods and standards of living are at stake for everyone who touches the NFL. The push-back on any decision to stop or drastically alter the course will be extreme.
There is no way to invest in a business knowing that it will someday end. Everyone assumes it will continue forever. If you don’t, you’re priced out of the market.
There is no mechanism for a business to return value to investors from an idea that has run its course. The only thing the business can do is let the investors sell their interests piecemeal, at ever declining values.
Could we be witnessing the start of a long, gradual sell-off into NFL bankruptcy? Will medical science make it possible to bang our heads against one another without lasting injury? Or will the NFL reinvent itself and the game to continue operating indefinitely, as everyone assumes it will, with no complaints?
The pace of business reinvention is proportional to the pressure applied by thinkers like Borland. Right now, there is no change. Will it start? Will it be fast enough? Time will tell.
ArtistBomb, Inc. has not pitched in front of any investor or group of angel investors in Boston. We’ve had plenty of practice, and plenty of one-on-one conversations with mentors and gatekeepers. Their questions and comments have surprised me. These folks aren’t what I thought.
The Investor Spectrum
At the far “conservative” end you have Ben Graham, a conservative unsurpassed by anyone. Ben Graham was Warren Buffett’s teacher. He said, above all, you need to have a margin of safety. Value a business assuming:
- egregious omissions or misdirection may exist in the information you have,
- growth will be no faster than at any time in the past, and probably much slower,
- the best picture of the business comes only from looking at many years of performance averaged together, especially down years, and
- if all else fails, you can sell the furniture.
Consider all this when you value a business, and if the business securities still look cheap, you have a margin of safety.
Warren Buffett and Charlie Munger took the idea of margin of safety and combined it with the idea of economic moats. Find a business with something truly unbeatable, like Coca Cola’s global recognition, and you can sleep easier at night knowing that no competitor can hold a candle to you.
At the extreme other end of the spectrum is Yosemite Sam, prospector and speculator. His investment strategy is characterized by hope out of proportion to evidence.
I thought all startup investors were like Yosemite Sam. That was my limited experience, anyway. In talking to angel investors in Boston about ArtistBomb, though, I’ve been surprised by how many of them care about margin of safety (like, revenue), economic moats (like unbeatable advantages), and track record (strong team). These investors are, at best, only a distant cousin to Yosemite Sam.
But Yosemite Sam is out there. Shouldn’t you just try to find him and be done with fundraising for a while?
Three Kinds of Funded Startups
I think you should probably forget about Yosemite Sam. The crummy startups that I’ve seen him fund have been either
- Digging in Fort Knox, OR
- His personal friend.
The great startups that I’ve seen funded by others have what conservative investors want (at least, appropriate to their level of development). They have margins and moats and track records. And because they have these things, they’re most likely going to work out just fine.
Is your startup up to the task? What do you think you’d do differently to get towards margins, moats, or track records? Let me know in the comments below.
Ask the question, “How should founders split startup equity?” and you will most likely receive a hand-wavy answer. Some offer blanket statements like, “The programmer should get at least 30%.” Others offer calculators or other arbitrary measures. These answers have never satisfied me. Before I offer a more rigorous approach, I’d like to play Devil’s Advocate for a moment and ask whether rigorous founder splits are even necessary. Here are three scenarios that cover the spectrum of possible outcomes:
- The company fails and is worth nothing.
- The company becomes successful as a going concern but its stock does not command a premium on any market, private or public.
- The company is successfully sold in part or in total for a premium in the market.
The first scenario is clearly moot. The second leaves the founder without an “exit.” As a going concern, however, the company will provide salary, perks, and other recognition that can compensate the founder beyond what a partial or total sale would. In this case, founder’s equity doesn’t really matter.
The third scenario is what entrepreneurs hope for. Imagine the startup is sold at a significant premium to its value as a going concern. The difference between 20% and 45% founder’s equity has huge dollar value difference, but probably little or no difference in terms of their new-found quality of life. They’re a successful entrepreneur with vastly more money and cachet for their next project. In some blowout exits, founders become rich even with just a sliver of starting equity.
Such a focus on dollar outcomes could tempt you to argue that equity splits are a “champagne problem,” that the only scenario in which they obtain significance is one in which the founders are so successful they don’t really matter. But you’d be wrong to argue so. Equity splits actually matter crucially in two spheres of a startup’s early business, without which any speculation of an exit would be in vain.
The first sphere is in founder relationships. Founders must be able to talk candidly about their relative strengths and weaknesses, their relative contributions, and their mutual and perhaps uneven commitments to one another. These difficult conversations cannot be glossed over, or else down the road, when more serious matters of success and failure are at hand, there will be no professional basis for frank and searching problem solving.
The second sphere is in that embryonic stage where no one is getting paid for their work. Everyone must be counted on to lift their share of the weight. Shares must be allocated with foresight of individual founder availability, skills, and financial resources. Otherwise a situation may be created in which the most able have a diminished incentive to work hard, on account of the least able receiving an apparently unfair percentage of equity.
It’s imperative that startups start out on the right foot by discussing candidly and concretely how much each founder is bringing to the table and signing up to contribute.
If you’re sold that equity splits matter, let me know in the comments below. If you want me to take it to the next level and offer a rigorous method for how founders split startup equity, let me know that, too.
Last Tuesday I had the chance to give an elevator pitch for ArtistBomb at Boston ENET. (The pitch was recorded, so I can post a link if it gets uploaded somewhere.) I’d like to share the formula I used so that you can adapt it for your own work.
What’s the Goal of an Elevator Pitch?
You want to convince someone in a very short amount of time to do something helpful to your business. At last week’s ENET meeting, I had 90 seconds. If I were actually in an elevator with someone, I’d have between 5 and 30 seconds.
I know the pitch I gave was effective because the three investors in the room, who got to make one comment or question after I spoke, didn’t use their moment to ask for clarification or to suggest a refinement. Rather, they each asked a logical follow-on question, indicating that they had understood all that I had said. If the format of the meeting had allowed for me to answer them, I would have engaged them all in meaningful conversation. What more can you ask for at a first meeting?
Generic Outline of an Elevator Pitch for Investors
ArtistBomb exists in the live music universe and does this great thing for these specific people. Unlike all of our competitors, ArtistBomb is different in this one significant way. This matters because those other companies are missing something.
For $30/mo, our customers can use our service, which solves their problem. We solve their problem by doing X, Y, and Z. This helps them make more money with less risk.
ArtistBomb just recently hit a significant milestone. We want to raise $X in the next couple of months so that we can hit the next milestones B and C.
If the investor to whom you’re speaking is interested, that’s all you need to say. If they have money and like the idea, they’ll express an interest. If not, they may ask a question. Or if they really don’t like you or the idea, they’ll say, “Well, good luck!” and that’s your answer.
What’s so Special about that Formula?
Imagine I started my pitch with paragraph three. The investors would have been distracted by their own internal interrogation, “What’s ArtistBomb? Should I already know what this is? Why don’t I know what he’s talking about?” That’s why you lead off instead with a broad statement about your company’s space.
What if you didn’t include a differentiator early on? Now your investors are distracted by a different internal monolog, “Oh great, another XYZ company. Just like that other one I don’t like.” You want to let your audience know why you’re different and better.
What if you didn’t include a firm price? Now you leave your audience wondering whether you have any monetization strategy. Most investors prefer to invest in businesses that make money. Otherwise, finding any net profit is going to be pretty tough.
The rest of the pitch adds to your credibility by providing details and indicating recent progress.
What do you think? Let me know in the comments below.
About a year ago I left Terrafugia and launched myself solo into Boston’s entrepreneurship scene. The advice given to me by a distant mentor was “find some local entrepreneurship resources and get involved.” I started by Googling. I was amazed by how much exists in Boston. Two groups in particular have earned a lot of my attention on account of their polished and varied programming:
IEEE Boston Entrepreneur’s Network
(Visit Boston ENET.)
The format of the meeting provides “as you like it” networking time way before, before, and after a set of three carefully screened and rehearsed presentations. Way before the meeting you can pay your own way to dinner at Bertucci’s. This is how I ended up meeting two of my eventual co-founders. At the meeting location itself there’s time to mix and mingle over sodas and snacks. After the meeting you can swarm the speakers or, even better, go introduce yourself to someone who asked an interesting question in front of the group.
The presentations are moderated, well timed, complementary perspectives on a single theme. For instance, this month’s meeting was “How do you know you’re ready to start a company?” The first speaker, Greg Skloot of Attendware, talked about the difference between tinkering on a project and really knowing that you have a business. The second speaker, Joe Baz of Above the Fold, gave insights into the personal aspects of entrepreneurship. Third we had Vicki Donlan, an impressively experienced consultant able to speak to a wide variety of startup success and dysfunction. We closed with Bill Seibel, whose resume slide made you turn to the person next to you and whisper “Wow.”
Every time I go to ENET:
- I meet someone helpful to my startup.
- I’m entertained by at least one charismatic and engaging speaker.
- I find a new role model of entrepreneurial success.
The Capital Network
This is like getting a laser-focused entrepreneur’s MBA for $400. Before I joined, I knew more than the average entrepreneur about debt and equity, about investment, and about business valuation. But the rules and norms for startups are usually a little different, and often they’re quite esoteric. For instance, when you buy $50,000 worth of stock of a publicly traded company worth $5,000,000, you get 1% of the company. When you buy the same amount from a startup worth the same thing, you get 0.99%. The reason is because of this difference: buying publicly traded stock gives you existing shares; buying startup stock causes new shares to be issued. If you’re thinking about taking investor money, this consideration and others must enter into your calculations, because the dilution effect on you means your share of the company will shrink with each investment round.
Unlike ENET, TCN often has a single speaker go for the full 90 minutes. In this format, the topics are meandering overviews of narrow subjects driven partly by slides and partly by audience questions. It’s a real good chance to ask about your specific startup. For instance, at the “founder issues” talk given by Paul Sweeney at Foley Hoag, we had a good audience-driven discussion about setting the strike price of stock options given to employees. (See my previous article here.) They also experiment with panels and roundtable discussions, which are helpful for giving diverse perspectives or more time in smaller groups.
Every time I go to a TCN lunch:
- I get delicious, healthy food.
- I can ask detailed questions of a knowledgeable speaker.
- I meet someone new starting an exciting business.
If you’re in Boston, you get access to lots of good Internet resources just the same as anyone else anywhere in the world. But these two groups are fun and, if you’re really going to do this for the first time, absolutely essential.
(The following was written on July 25 as the first part of an entry to the Value Investing Challenge. It was just an exercise, as I didn’t meet the criteria for entry. I never developed the figures to go along with the text. Maybe you’ll find it useful. Remember that it’s not about the stock, it’s about the stock and the price. In other words, just because I liked it back then doesn’t mean I like it now. This is not a recommendation for you to buy. Caveat investor.)
The stock market is on a tear, having doubled in the last four years from the mid-recession lows of 2009. But over the same period, steel stocks have suffered. ArcelorMittal and US Steel, the first and 13th largest makers by tonnage, are down 50% over the same period. The cause surely lies among the 2nd through the 12th largest steelmakers, all of which are in Asia, seven of which are in China. The Chinese government and others find it in their economic interest to increase steel capacity locally without regard to global demand. In China alone, tonnage increased over 75% in the four years from 2007 to 2011. Would that they were alone. The same excess capacity plagues all steel companies, who continue to build new plants for greater efficiencies and lower costs. ArcelorMittal are especially hard hit, as they must obtain government permission before mothballing any of their plants in the EU region. Their per share earnings are down 160% since pre-recession mediums seven years ago, putting them solidly into losses. US Steel is also losing money, with its per-share earnings down 110% from 2006 averages.
In the midst of this oversupply chaos sits a placid Korean company with an unassuming name: POSCO. Averaging the previous seven years, which encompass both good times and bad, POSCO’s earnings margin has been 7%, roughly double that of ArcelorMIttal and seven times that of US Steel over the same period. That margin would allow POSCO management to let prices drop 7% while doing nothing and still remain profitable. But we can delight that their steadfast management have already taken action. Unlike ArcelorMittal, who in their worst year had enough operating cash to pay only two-thirds of their interest, or United States Steel, who in their worst year dipped into the piggybank in a big way, POSCO has averaged more than twice the operating cash they need to pay their senior debt. That’s a nice assurance for an equity holder. Over the last seven years, they’ve brought in cash equal to almost 28 (twenty-eight!) times what they paid in interest. Compare this to ArcelorMittal or United States Steel, the best of which brought in only six times what they paid in interest over that seven year period.
POSCO is unique among the steel companies listed on US exchanges in its prudent non-unionized management of employees. Whereas “the majority” of the 245,000 employees at ArcelorMittal are unionized, and likewise for US Steel’s 49,000, only 10 (ten!) employees of POSCO’s 35,000 are. It should be noted that this difference will be material over the long term. Indeed, it’s already being felt. In 2008, United States Steel recognized billions of dollars of “accumulated other comprehensive losses,” which per GAAP at that time did not appear on the income statement, due primarily to defined benefit pension obligations to union employees. This weighs on their record of past performance, and given the industry headwinds and their high-wage, expensive-currency home country, should lead a careful investor to expect more trouble to come of this.
Steelmaker POSCO sounds like a relative beauty, but might we just be wearing beer goggles? POSCO has historically earned most of its revenue in South Korea, a market they see as nearing maturity. Also, they sit alongside one of the world’s last great lunatics, Kim Jong-un, who has his finger on a button that would write him into the history books for all time and destroy many of POSCO’s assets in the process. And as far as the steel industry goes, the worst is yet to come. By some estimates, demand won’t reach supply for another five years. What will happen to our fair POSCO? Let’s look at each fear in turn.
POSCO, as it turns out, is focused neither just on Korea nor just on steelmaking. Management there have seen how their home market has matured and have taken steps to diversify. In 2012, half of their revenue came from overseas. Because they pair revenue and expenses in local currencies, they’ve been relatively immune to currency effects. Surprisingly, they aspire to be more than a steel maker. They acquired Daewoo International in 2010, giving them a global trading company for all kinds of things (cotton, for instance). Daewoo matches buyers and sellers before it commits to any inventory, so it has very little inventory risk, and has to carry committed inventory during shipping for as little as 23 days until the buyer receives and pays. Korea subsidizes the company to perform energy exploration, as well. If they succeed in finding natural gas, for instance, they pay the government back as a simple loan. And if they fail, they pay back nothing. POSCO also uses its steel for construction projects. Their 89.5% owned subsidiary, POSCO Engineering & Construction, performs jobs all over the world. Last year, about a third of their profit came from non-steel activities.
What about North Korea? While we can never know for sure, we can talk about certain mitigating circumstances. Their large plants, Pohang and Gwangyang, are about as far from North Korea as you can be and still be in South Korea. If you’re feeling lucky, that’s plenty of time for a rocket to go haywire. Their construction project in India’s Orissa state is going ahead and will give them an overseas manufacturing capability. When we look at the price of South Korean bonds, and compare that to the price of bonds in Belgium before the outbreak of World War II, we find no parallels whatsoever. In fact, the market sentiment is that South Korea is pretty safe. And overall, we know from history that markets and businesses continue to function even in times of war. If it’s to come, we could do worse than to be invested in a steel maker that will be high on the government’s list of protectees.
Will the next few years be a steel industry bloodbath? It’s impossible to say, but we can see that POSCO has the best financial position, in terms of high earnings margin and low debt, of any large steel maker on US exchanges. More than that, it’s in an objectively good position. We can also wonder and hope that Berkshire Hathaway, already a 5% owner, would act as a back-stop should any crisis occur. I’d like to add that POSCO’s core steelmaking business may be the most advanced in the world. As proof I cite the numerous anti-dumping provisions aimed at POSCO, which indicate that it’s better able to provide low-cost steel than many homegrown steelmakers. Their Gwangyang plant, for instance, is entirely automated and can make a hot rolled product in four hours, start to finish. They’re also a good global citizen. They’re complying with the Kyoto protocols. They’ve had a chrome-free steel offering since 2006 (hexavalent chromium is a repeat offender in steel making and they’ve done away with it entirely). They also hold interesting patents in processes like FINEX, which make steel cheaper with less nitrous oxide and sulfur dioxide. And as if that weren’t enough, they keep about 1,000 scientists on staff at a local university finding ways to keep their plants operating with an environmental friendliness and far-sighted mentality that you don’t see in a company worried about surviving a few lean years. If all this doesn’t convince you of their merits, let’s return to some hard facts: their plants have been operating at over 100% capacity. So when they reduce output, as they have said they would, it will be starting from above maximum. That’s not a bad place to be.
An investor in the United States looking to purchase shares of POSCO can do so most readily through their American Depository Receipts, traded on the New York Stock Exchange. These receipts represent one quarter of a share and come with fees to purchase, sell, and receive dividend payments. They recently amended the fee schedule to increase fees paid on dividends. There are also tax implications, because Korea withholds taxes even when dividends are paid to non-Korean investors. Even with this factored in, investors seem to pay very little for the chance to own one of the world’s greatest steelmakers.
By now you’ve heard that the iconic Washington Post, the newspaper that toppled Richard Nixon from the presidency in 1974, was sold at a pittance (relative to what it would have been 15 years ago) to the very wealthy and very capable founder of Amazon, Jeff Bezos. I can’t tell you what will happen, but I can give you some food for thought.
- This is not the first time Bezos has made big personal investments. He bought huge pieces of Pets.com and Kozmo.com. Both of those went bankrupt.
- The Post, according to Don Graham, has suffered declining revenue seven years running. In the first quarter of this year, the paper lost $34 million from operations.
- Bezos paid $250 million in cash to buy the paper. As a percentage of his personal net worth, that’s equivalent to the median American family paying $2,000 for a car. It’s a very manageable amount of money for him. If the paper runs losses for a long time, he can keep re-upping.
- At the current subscription price of roughly $180/yr, Bezos needs another 750,000 subscribers to break even.
Why should anyone subscribe?
What can a subscriber to the Washington Post get that they can’t get anywhere else?
Warren Buffett has taken an interest in local newspapers as the only source of local information. He said (p. 17):A reader’s eyes may glaze over after they take in a couple of paragraphs about Canadian tariffs or political developments in Pakistan; a story about the reader himself or his neighbors will be read to the end.
That’s one of two directions I think Bezos and the Post will settle on. The Washington Post can still be the source for local news in DC.
Can it maintain national readership?
I think so. Bezos said he’s going to pay close attention to what readers want: “Our touchstone will be readers, understanding what they care about – government, local leaders, restaurant openings, scout troops, businesses, charities, governors, sports – and working backwards from there.” Just look at how much of that is local, how little of that is Watergate-esque!
But if he can afford to wait a while and to keep really good government journalism going at the Post, he may be able to bankroll a level of government journalism above anything being done by anyone else. That would be a differentiator, and with a subscription model for digital or Amazon’s distribution system for print, that might be a story worth paying for.
Do you agree? Let me know in the comments below, or share this food for thought with a friend.
Is South Korea going to be attacked? Well, we can get a sense for market opinion by analogy with World War II.
Back in 2004, Financial History Review published an article correlating market events with World War II events. In particular, they looked at the prices of Nazi German bonds and Belgian bonds. Below is an example of Belgian bonds traded in Zurich. Before the invasion, starting in about 1936-37, the market slowly started demanding lower and lower prices (higher and higher yields) for taking the risk of buying bonds from Belgium. When Poland was invaded in 1939, Belgian bond prices dropped sharply. When Belgium itself was invaded, trading was briefly suspended (break in data), but then resumed at far lower prices (higher yields):
You can read the full article here.
So what’s going on with South Korea’s borrowing? Are investors demanding a high risk premium for buying South Korean debt? The answer is basically “no.” Here’s a graph of yield for South Korean bonds (you’ll have to mentally invert it to compare it to the graph above, which shows prices):
Over the last two years, buyers of South Korean bonds have been accepting lower and lower yields (higher and higher prices). There’s a slight uptick at the very end there, but overall, investors in aggregate seem to be saying that South Korea will be just fine.
But it’s hard to say, especially with menacing North Korean displays like this.
This recently blew my mind, so I thought I’d share some simple math with you.
Imagine an investor wants to invest in your startup. He says it’s worth $1 million and he wants to invest $500,000. He’s going to take half your company, right? Wrong. He’s going to take one third. At least, that’s the usual math.
In publicly traded stocks, it works the way I’d expect. If I buy $500,000 worth of stock in a company with a capitalization of $1 million, I’ll own half the company. That’s because my stock came from other stockholders. My money went to pay out existing owners.
In the startup world, that’s very unusual. All the old money has to stay to keep the business alive. There’s no “capitalization” yet, not in the sense of capital sitting there doing its job. So when someone invests in your startup, they don’t buy shares from existing owners. They add to its value.
So in the example above,
Don’t believe me? Think about it in terms of share price. Say you have 1 million shares. A $1 million valuation divided by 1 million shares = $1/share. The new investor buys 500,000 shares in your company at $1/share, equaling his $500,000 investment. You create those shares by issuing new shares, rather than by selling him existing shares. Now there are 1.5 million shares out there, and he owns 500,000. So what does the investor own? One third.