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Too-Big-To-Fail Goldman Buys Facebook Share

As a former founder and CEO of a public company, I understand why Facebook founder Mark Zuckerberg wants to raise money without taking his company public. During the dot.com bubble ten years ago, many companies, including mine, went public too soon – most before they were profitable, some before they even had revenue. Nevertheless, the announced deal between Goldman Sachs, Russian investor Digital Sky Technologies, and Facebook is disturbing both because Goldman was one of the banks considered too big to fail by the Federal Reserve and because the federal regulations on how many investors a company can have before going public is being used, as regulation often is, to favor big banks and big companies.

The details of the deal as described in a New York Times article by Susanne Craig and Andrew Ross Sorkin: "Facebook has raised $500 million from Goldman Sachs and a Russian investor in a transaction that values the company at $50 billion, according to people involved in the transaction. As part of its deal with Facebook, Goldman is expected to raise as much as $1.5 billion from investors for Facebook."

Further according to The Times article: "On Sunday night, a number of Goldman clients received an email from their Goldman broker, offering them the opportunity to invest in an unnamed 'private company that is considering a transaction to raise additional capital.' Another person briefed on the deal said that Goldman clients would have to pony up a minimum of $2 million to invest and would be prohibited from selling their shares until 2013."

So what's not to like about the deal? Don't we want private sector investment? Risk taking?

Too Big To Fail

The deal reportedly values Facebook at $50 billion. Could be too much; but that's certainly a risk that Goldman and its wealthier clients are equipped to take, isn't it? Sure… except if we are expected to bail them out again if their investments go sour. Nothing substantive has changed since the last bailout , when the Federal Reserve gave Goldman 52 separate infusions with a high balance owed of $18 billion (all of which has been paid back). Goldman is, if anything, an even bigger and more important part of the entire financial structure. It's not that this one deal could even dent Goldman; still, they are playing a heads we win, tails you bail us out game. They get a privileged seat at the investment table; and, if they don't play their cards right, they get lent new table stakes by the Fed at concessionary rates, while the smaller players are forced to fold for lack of capital.

We don't want the government regulating what risks Goldman and its clients take; that a sure way to freeze and politicize the risk taking and private investment we need. That means we either have to change the law so that the Fed cannot repeat the kind of bailout it did last time around – and investors know this and can act accordingly – or we need a preemptive round of financial trust busting leaving no entities standing that are too big to fail.

Access to Public Markets

In an over-reaction to the dot.com bust, a law known as Sarbanes-Oxley was passed requiring much greater disclosure by publicly-traded companies. A consequence of this, whether intended or not, is that small companies can no longer afford the accounting required to be public. It is also true that the transparency required of a public company may be a bad idea for a startup which has good reason to keep its successes and failures secret from competitors and imitators. Moreover, quarterly reporting with an emphasis on short term results is not a great way to run any company and can easily be a fatal distraction to a company which needs to focus on long term value.

The SEC allows a company to have up to 499 investors without being public (state law varies). A secondary market in the shares of private companies has grown up including online exchanges like SecondMarket, which says it has "More than 30,000 participants, including global financial institutions, hedge funds, private equity firms, corporations and high net worth individuals". This is a largely unregulated market in which participants invest at their own risk. An investor can decide whether she wants to invest in a company which is not making public disclosure of its results and is not regulated by the SEC.

But the restriction that company have less than 500 investors is leading to the formation of investor pools which act as a single investor. Certainly this is legit when the investment pool, a VC firm or a pension fund, has many investments; but what if the pool was formed just to skirt the rule on having too many investors in a single private company? According to Bloomberg, the SEC is investigating this practice. It seems from the little information available, that this is exactly what Goldman is doing in the case of Facebook to allow its favored accounts to buy shares.

I'm not convinced more regulation by the SEC is a help to anyone; the illusion of oversight is dangerous to investors. Remember Enron and Bernie Madoff – remember the underreporting of underfunded pension plans, particularly in the public sector, and all those publicly-traded banks which were suddenly insolvent. An honest caveat emptor might be more helpful. The simplest thing may just be to lift the arbitrary limit on the number of investors a company can have without being forced to be "public".

There certainly shouldn't be one rule for Goldman and its clients and another rule for everyone else. Small companies need access to risk equity (not a guarantee of funding, just access) to allow them to compete with companies big enough to make their own deal with Goldman.

See Socialist Senator Sanders Saves Capitalism for more on the bailout of Goldman.

See Public Company – Deciding To Do It for the price a small company makes pays to go public.

See AT&T: Lesson From the Crypt #1: Don't Manage for Quarterly Results for why neither large nor small companies should manage for quarterly results.

My novel, hackoff.com: an historic murder mystery set in the Internet bubble and rubble has plenty of hair-raising stories about investment banks during the dot.com era as well as the story of a fictional company that went public too soon.

Raising Money in Tough Times

The best time to SUCCEED in raising money is when money is hard to get - like now, for example. When capital is easy to get, your competitors (who are, of course, much less deserving) will have plenty of capital, too. Dumb spending or pricing by them may “force” you to do the same. In the end, easy capital may not give you any advantage at all and you pay for it with part of your company.

Capital is a coward; the sound of popping bubbles sends it burrowing under the mattress for safety. Your tech startup is not in any way related to the sub-prime housing market or to the imploding debt of leveraged buyouts. Nevertheless, if you go out for money now, you are searching for a spooked commodity. You may just be wasting your time. But, if you get the money, it puts you at a huge advantage to unfunded competitors. BTW, your competitors include everyone else jockeying for attention in the new product and service marketplace whether they compete directly with you or not.

There is a fundamental difference in what scared investors look at compared to greedy, bold investors.

Greedy, bold investors (which is what you have while bubbles inflate) don’t worry much about fundamentals; they are too busy making sure they get seats at the table – any table. That strategy actually works at the beginning of bubbles (and Ponzi schemes); those who get in AND OUT early get rich – they really do: that’s what attracts everyone else. Obviously this happens not only in high tech but also in residential real estate and tulip bulbs: it’s a fundamental part of the economic cycle.

But frightened investors (which is what you have when bubbles pop) are worried not only about the fundamentals of the company but also all the external things you, the entrepreneur, don’t control. What if your market implodes through no fault of yours? What if the time comes to raise your next round and, even though you’ve met and exceeded all your objectives, ALL the money in the world is in hiding? Oh, dear.

So, if you’ve decided to raise money now (or have no choice), you have to address these fears. Here’s a few suggestions:

  1. present a plan of reasonably achievable singles and doubles, not home runs. Remember you’re selling against fear, not to greed.
  2. present a plan which is a believable projection of what you (either as a company or as principals) have already achieved.
  3. instead of the automatic assumption that another round of financing’ll be available at a reasonable price when you need it, have a Plan B which includes going forward with NO additional financing.
  4. consider making Plan B above your Plan A. If the market opens up and the company has done as well as you think it will, you can always change your mind.
  5. show the investors how the addition of their money to your already excellent company will create a virtually unassailable position vs. potential competitors.

There is money out there; it’s just hiding. There are venture funds which have commitments for funds they’d dearly like to put to work. Credit is cheap for the most credit worthy (which doesn’t usually include startups), because credit is unavailable for everyone else and banks have to put their money somewhere. The terms you’ll get now are not as good as the terms you can get when there’s more money than ideas; but the money may be worth much more if you get it.

Good luck.

See a related post by my friend VC Rob Shurtleff on the perils of Bridges to Nowhere - on the perils of funding rounds that are too small to cross a chasm with.

Happy Hour

Next Tuesday, Feb 5th, I'll be a guest on the Happy Hour show hosted by my friend Cody Willard (2d from left). The show is on FoxBusiness Network every weekday from 5 to 6 PM; appropriately, it's broadcast from the Bull and Bear Bar in the Waldorf Astoria. Below is an episode from last week.

Note: If you can't see the video below, link here.

Even if your local cable or satellite network doesn't carry Fox Business (DirecTV channel is 359, not on Dish) all segments from the show are available as video at www.foxbusiness.com. Trick is to go there, click on VIDEO in the horizontal menu bar, then scroll down to the Search for Videos box in the middle of the new page (don't use the search box at the top of the page), enter "Happy Hour", and click Search.  Each segment (guest) of each Happy Hour show is then accessible. Since it's broadcast live (and then, again, at 11 PM) the segment obviously won't be on the web until after it appears on the air but they do seem to go up almost immediately after they happen.

Don't know quite what we'll talk about but Cody is good at making almost anything fun and puncturing pomposity in guests. Hope you'll join us on TV or on the Web. BTW, you can rate the segment on the web. If you come to the bar, we can have a drink and you can tell me how I did in person.

In Defense of Bubbles

The press is full of stories of people who’ve been hurt by the housing bubble, people who borrowed too much and now face losing their homes because both the housing bubble and the sub-prime credit bubble are – not coincidently – ending at the same time. What’s missing from the press I read are stories of people who bought homes before the bubble, didn’t refinance extravagantly or sold and took profits, and now have a nice nest egg. What’s also missing are the stories of people who got credit even though they would not have qualified previously and now own partially-paid-for homes as a result.


There is no question that there are families in real trouble because of over-easy credit. There is no question that lenders and those who finance them got greedy and extended credit they never should have extended. There may be a social purpose in helping some of the former; there is no social or economic reason to help the latter. It would be bad policy to do so.


But we don’t want to eliminate future bubbles; bubbles do more harm good than good harm.


You wouldn’t believe that assertion if you read the story in this morning’s NY Times about American’s adjusted growth income from 2000 to 2005 headlined 2005 Incomes, on Average, Still Below 2000 Peak. The story contains this dismal graph:



Sure enough, if you measure from peak year 2000 when there was a huge stock market sell off (meaning many, many people were taking gains even if they weren’t selling at highs), you find that adjusted gross income (inflation adjusted) hasn’t recovered.


It took a little work since The Times didn’t deign to give URLs of its source; but I went back to IRS reports that describe the period covered in this graph (http://www.irs.gov/pub/irs-soi/05intba.xls and http://www.irs.gov/pub/irs-soi/01intba.xls) and extended back in time to get some perspective (http://www.irs.gov/pub/irs-soi/97ina.xls). The resulting graph tells a different story:


Image003 


Incomes started to rise rapidly in the late 1990s as the bubble got underway. They did collapse FROM THEIR HIGHS as the bubble burst; they never fell back to the pre-bubble level (inflation adjusted) of 1996. If anything the bubble seems to have spurred a faster long-term trend in income growth (but this graph alone doesn’t prove that). It’s a fact that the bubble of late 1990s paid for the infrastructure on which the Internet has grown.


And, with hindsight, I think we’ll find that the housing bubble financed a permanent upward bump in the balance sheet of many American families AND made home ownership – continued home ownership possible for people lenders would have turned away.


Snarky notes for math nerds: when you put numbers together from different sources and double-check them, you find funny things. The NY Times (or its unnamed source) think that $7,422,495,663,000 (total US AGI in 2005) rounds to $7.43 trillion. The IRS incorrectly inflation-adjusted AGI for 1997 in some of the spreadsheets cited above (I corrected).


The first post ever on Fractals of Change was about the great Internet bubble and the reason why this blog’s motto is “nothing great is ever accomplished without irrational exuberance”.

Chat Groups

Any exCEO understands the temptation to participate in Yahoo chat groups which Whole Foods CEO John Mackey now apologizes for giving in to. Despite being cesspools of foul language, misinformation, stock pumping and pummeling, and adolescent fantasies, the chat groups which formed around every public company were an integral and influential part of the last Internet bubble and rubble.

No sane CEO should have spent much time looking at the garbage posted anonymously; almost every one of us CEOs kept a browser window open on the chat group formed around our stock symbol – but this wasn’t a time of sanity. We had two excuses for doing this:

  1. Our stockholders ranging from rank amateurs to sophisticated mutual fund managers were watching the same chat groups (you can tell by their questions). Surely we had to know what they were reading.
  2. The chat groups provide instant feedback. If a press release is unclear, you can tell by the chat group. You can even gauge in real time your performance during a live webcast earnings conference and clarify on the fly (but you lose your concentration so this isn’t really a good idea).

Mary and I resisted the temptation to join in the discussions(?) either anonymously or under our own names; but it was difficult. It was company policy that any employee participating in the ITXC chat group might be fired. The risk was simply too great of running afoul of the Security and Exchange Commissions’ Reg FD regarding non-public disclosure of data about a public company (no one wanted to be the test case for whether a chat group is public enough or not), disclosing data which shouldn’t have been disclosed, or making a misstatement.

On a couple of occasions we corrected a gross error of fact officially as the company when we felt that we had, in some way, contributed to misunderstanding. Lawyers didn’t even like that because it might have implied that we now had a responsibility to correct every bit of incorrect information or analysis which appeared on the chat group. I also remember sending a lawyer letter to Yahoo because a poster was pretending to be my son. Yahoo didn’t reply substantively but that poster disappeared from the board.

If blogs had existed then, I probably would have blogged at least partly as a counterpoint to the chat groups, not that lawyers would have liked that any better.

There is, of course, a chat group in my novel hackoff.com: an historic murder mystery set in the Internet bubble and rubble. When you read the excerpt below – carefully keeping it from your children, you’ll have a hard time believing that I actually toned the language down but that’s the case. This chat takes place as the news reaches the market of the death of hackoff.com CEO Larry Lazard by bullet wound to the head and the accession of ex-swimsuit model and CFO Donna Langhorne to the CEOship.

Oh-Oh
by: thewatcher02 (38/M/New Rochelle, NY)                           04/01/03 9:40 am
Msg: 99020 of 99034
hackoff’s not trading!

Re: Oh-Oh
by: ChorusLine (25/F/Paramus, NJ)
Long-Term Sentiment: Buy                                                    04/01/03 9:41 am
Msg: 99021 of 99034
Posted as a reply to: Msg 99020 by thewatcher02
Got to be an april fools joke:-}

Re: Oh-Oh
by: pooper
Long-Term Sentiment: Sell                                                    04/01/03 9:43 am
Msg: 99022 of 99034
Posted as a reply to: Msg 99021 by ChorusLine
The real April Fool’s joke is George Bush

Re: Press Advisory Out
by: Jumbo10 (46/M/New York, NY)
Long-Term Sentiment: Buy                                                    04/01/03 9:45 am
Msg: 99023 of 99034
There is a press advisory out for an announcement expected at 10AM explaining the halt in trading. Whatever it is, you can bet it’ll be good for the crooks on wall street and bad for everyone stupid enough to be holding the stock.

Re: Oh-Oh
by: scooper
Long-Term Sentiment: Buy                                                    04/01/03 9:48 am
Msg: 99024 of 99034
Posted as a reply to: Msg 99022 by pooper
pooper, your just as much an asshole as your buddy clinton and this is not a political board

Re: Press Advisory Out
by: Alaska60-60
Long-Term Sentiment: Strong Sell                                       04/01/03 9:52 am
Msg: 99025 of 99034
Posted as a reply to: Msg 99023 by jumbo10
I’ve been telling you idiots allalong that lizard would have to sell jerkoff to antihack. he probly just didn’t get his own parachute big enuf b4 but I heard from insider that the deal is definitly on now. of coarse they stopped trading so only insiders can benfit but thats how lizards are

Re: Press Advisory Out
by: scooper
Long-Term Sentiment: Buy                                                    04/01/03 9:56 am
Msg: 99026 of 99034
Posted as a reply to: Msg 99025 by Alaska60-60
alaska, your as much an asshole as your friend pooper and this is not the antihack board. why dont you stay there where you belong so you can pump and dump that and not bother us here on this board

Press Release Out
by: Alaska60-60
Long-Term Sentiment: Strong Sell                                       04/01/03 10:01 am
Msg: 99027 of 99034
Posted as a reply to: Msg 99025 by Alaska60-60
The press release is on Yahoo.  The lizard is out and the cunt is in…  this stock is in the crapper if it ever starts trading again

Re: Press Advisory Out
by: Jumbo10 (46/M/New York, NY)
Long-Term Sentiment: Buy                                                    04/01/03 10:05 am
Msg: 99028 of 99034
Posted as a reply to: Msg 99023 by jumbo10
This may not be bad for the stock. I’ve changed my sentiment to buy and will buy after it settles down after trading resumes. Donna may be smarter than Larry was about selling the company or making it profitable. She always did a better job than he did at the quarterly webcasts. Often regime change makes a company go up even when it is unexpected.

Re: Press Advisory Out
by: PacPhil (25/M/New York, NY)
Long-Term Sentiment: Buy                                                    04/01/03 10:07 am
Msg: 99029 of 99034
Posted as a reply to: Msg 99028 by jumbo10
Jumbo, you always have good analysis. I hope you’ll write more later in the day. Why do you think Larry shot himself?  Does that matter to the stock?  Is the new CFO any good?  What will The Street think?

Re: Press Advisory Out
by: Alaska60-60
Long-Term Sentiment: Strong Sell                                       04/01/03 10:10 am
Msg: 99030 of 99034
Posted as a reply to: Msg 99028 by jumbo10
Your an idiot or just getting reddy to dump your stock. The cunt cant run the company. the lizard couldnt run the company. The company sucks. it doesn’t have anything. They should have sold to antihack… now noone will pay a penny for this piece of shit

Whats Happening
by: CLess                                                                                04/01/03 10:15 am
Msg: 99031 of 99034
Does anyone know why the stock isn’t trading???

Donna
by: TestTost (35/M/San Francisco, CA)
Long-Term Sentiment: Strong Buy                                       04/01/03 10:15 am
Msg: 99032 of 99034
Donna’s a peace of ass.  She was in the SI Swimsuit addition in the early 90s.  She’s still hot.

Re: Oh-Oh
by: ChorusLine (25/F/Paramus, NJ)
Long-Term Sentiment: Buy                                                    04/01/03 10:16 am
Msg: 99033 of 99034
Posted as a reply to: Msg 99021 by ChorusLine
It wasn’t an april fools joke.  what will the street think?

Stock Opened
by: thewatcher02 (38/M/New Rochelle, NY)                           04/01/03 10:16 am
Msg: 99034 of 99034
hackoff’s trading again! 1k shares at 1.26 unchanged. bid 1.24; ask 1.26.

Book Tour – South Burlington, VT and Hanover, NH

Two weeks from tomorrow on Saturday, February 10, I’ll be at the Borders Express (formerly Waldenbooks) in University Mall, 55 Dorset Street, South Burlington, VT from noon to two.

On Saturday, March 24, I’ll be at the Dartmouth Bookstore, 33 South Main Street, Hanover, NH at 7PM.

At both places I’ll be reading from hackoff.com: an historic murder mystery set in the Internet bubble and rubble, signing copies, and glad to talk about the book, my blog Fractals of Change, or anything else you like.  Hope to see you at one of these places if you live here or are visiting for the now great skiing.

Changing Ingredients for Web 2.0 Success – Continued with Reader Help

More money, I posted, is needed for web 2.0 success now that everyone knows you can start a web 2.0 company on a shoestring. Readers of Fractals of Change have added useful breath and depth to the discussion both in the comments on that post and on their own blogs.

Brian Oberkirch blogs that there are other uses for more money than just PR (I should have been more clear about this. He’s certainly right). “The thing startups have to spend capital on is this: time. Nuance and pitch-perfect user experience are going to sort winners from losers. That takes time, community engagement, trial and error, a team.”  He cites slow-build successes like FeedBurner, WordPress, and 30Boxes who have built great value slowly rather than hurried to an early exit.

ESPECIALLY, if you’re gonna end up spending money on PR, you wanna get the product right before you start trumpeting it. Stowe Boyd picks up on this very well:  “Companies that squander their first launch with less than the "social tipping point" -- the minimum level of social features that will engender viral uptake -- will simply fall from view. There's too much innovation, too many apps, too many releases, too much to waste people's time with a half-baked product. Get it right, or you will disappear into the dustbin of failed promise.”

Stowe also laments the number of me-too products and suggests moving into the “white space” of unmet needs.

History can teach the wrong lessons because each novelty is a novelty only once. You can’t be a “me-too” novelty.  When del.icio.us first launched it had an almost impenetrable UI.  People took the trouble to learn to use it because it was an incredibly useful clipping service; enough people used it so that it benefited from the network effect of being an aggregator of many people’s clippings.  The rest is history - but DON’T try to repeat it.  One, as Stowe points out, there are already enough clipping and general purpose “also liked” services; two, since you’re going to pay dearly one way or the other to get attention, you don’t want to squander the one and only time people link from TechCrunch to your product with an unsatisfactory experience.

Reader crunchback comments:  “Raising "enough money" as you say, is key. Sometimes the right amount is $0. None, nada... …For most Web 2 entrepreneurs, the path to riches is bootstrapping or lightly funding a business that has a real revenue model out of the gate. It ain't as cool as telling all your buddies about how you closed a round that makes you worth $30m on paper. But the paper's worthless and for most Web 2.0 VC investments will stay that way….”

Seems like a contradiction to the thesis that you need MORE money to succeed but it isn’t. If you raise too much money too soon, you will be under great pressure from investors to produce results. This can lead to premature release of products, shoddy execution, or simply selling out too soon. On the other hand, if you can use just a little money to get to the point where you demonstrate great potential (revenue’s not a bad benchmark nor is it the only one), then you can raise the larger sums you’ll need later at a better multiple. Very much why Fred Wilson talks about smaller initial investments by his fund leading to larger investments later.

Come to think of it, the Web 1.0 bubble was an example of too much money way too soon.  Nothing compares with the pressure and expectations of being a public company. (OK, I’ll stop whining.)

Reader Rick Burnes comments:  “A lot of what you're saying is based on the idea that TechCrunch, A VC and Boing Boing are the blogs you have to get mentioned on in order to succeed. That's not necessarily true. Many current startups focus on verticals where these blogs are irrelevant and the bloggers that do matter have far less Web 2.0 noise to deal with.”

Excellent point.  It’s much easier to get to a critical mass of attention in a segment of the market than the whole market. If you’re introducing a vertical market product, you want attention which is focused on and credible to prospects in that market – not the general market. Even if you have a broad market product, you may well want to start by getting to a critical mass of attention in a subset of the market – then emerge from your beachhead both with more funding and a core of users.

Yahoo.licio.us is about del.icio.us and network effect.

Web 2.0 – Greater Initial Investments Required

Michael Arrington posted today on TechCrunch on the death of some Web 2.0 companies and the question of whether we are seeing another bubble burst.  He thinks not: “I think a few failures are direct evidence that we are not in a bubble and that the private venture markets are actually in the process of letting off a little steam to keep things rational.”

I think we’re seeing the beginning of a change in the required funding model for Web 2.0 companies.

Later in the post Michael (correctly) cites Digg, YouTube, and FaceBook as successful Web 2.0 companies that were started on a shoestring.  But that was then; this is now.

Fred Wilson posted a week or so ago that Web 2.0 companies are a gift to VCs.  His thesis is that companies require less initial capital now because it costs so much less for servers and service development than it did in the Web 1.0 days but that successful startups will still constructively consume capital (a good thing from a VC’s POV) as they grow to scale and commercial success.  Fred says: “What they figured out was how to build a web service for less than couple hundred thousand dollars (more than an order of magnitude less than people were spending at the top of the first bubble).”

Fred tells how he’s seen web 2.0 startups get more traffic in a day from favorable blog mentions than web 1.0 companies got in their entire lifetime from expensive portal deals.  So, he reasons, the cost of promotion is much lower than it used to be as well. 

I think Fred is right about the immediate past; I think he’s partly wrong about the future.

The first companies that figured out that you could launch a company on a shoestring because the cost of development was low and the blogosphere could be used for promotion were right and the good ones were handsomely rewarded.  The problem is that “everyone” knows that now.  There are a plethora of companies being started on a shoestring; there are a double plethora of fast imitators of each shoestring-launched company that begins to look successful.  After all, just as Michael and Fred have pointed out, the price of entry is incredibly low.

Moreover, it is no longer easy to get mentioned on blogs that count (for launching new products) like Michael’s TechCrunch, Fred’s A VC, or Boing Boing. Nor is it easy to get dugg significantly on digg or get a high ranking on del.icio.us. Low startup costs mean too many contenders.  New cottage industries plus associated scams have popped up to improve not only Google ranking but ranking on the social networking sites as well.

So, if you’re just now starting up, don’t get blinded by the successes of the first people to realize a platform could be built and operated on the cheap.  You already missed that wave.  Now, unless you are extraordinarily lucky or well-connected, you aren’t going to succeed in publicizing your new service and getting up to a critical mass of content or subscribers or both unless you raise or have enough money to create initial awareness or value.  There is too much clutter from which you must emerge.

You may have to spend money creating a valuable aggregation of content in order to attract subscribers in sufficient numbers so that they add additional value to the content and create network effect for your startup.  You may have to invest in advertising on blogs and other media; this isn’t nearly as effective as editorial mention but editorial mention is getting hard to come by.

I’m a nerd; I’d love to believe that building a better mousetrap is all that’s required.  This was somewhat true for the last couple of years; nerd nirvana.  But now the lesson that marketing Mary, my wife, is always drumming into my head is coming true again: you gotta market.  And marketing cost money.

There will be plenty of Web 2.0 successes to come.  But I’ll bet most of the ones that do succeed will have raised enough money in their first year to rocket themselves out of the clutter.  That probably means a few million dollars plus a very, very good plan to spend it.

Update: Changing Ingredients for Web 2.0 Success – Continued with Reader Help

Continues the discussion.

Vonage IPO – How The Bankers May Make a Bundle More Despite the Bust

In some case, the bankers who manage a stock offering can make more money from a bust than a success. It happens when the green shoe drops.

If you look at the front page of the Vonage prospectus, you will see that the banks (called “underwiters”) which took Vonage (called “the company” in prospectus terms) public – Citigroup was the lead bank – earned $31,875,000 in commissions.  Not bad but that’s not quite all.  A little further down on the front page is this line:

“We have granted the underwriters an option to purchase up to 4,687,500 additional shares of common stock to cover over-allotments.”

This is an absolutely standard provision in stock offerings and potentially a very lucrative one.  The over-allotment is commonly known as the green shoe.  The underwriters have thirty days in which they can buy these extra shares at the IPO price.  It’s obvious that, if the stock goes up, the bankers can profit by buying at the IPO price and then selling at the market price.  For example, if Vonage stock were to go up 25% from the offering price, then the over-allotment option would be worth $19,921,875.00 (.25x$17x4,687,500).  Not bad at all.  In the salad days of Bubble 1.0, when stocks typically doubled or tripled postIPO, think what this was worth.  Of course, the company does get extra money by selling the extra shares but has to sell them to the underwriters at the IPO price.

The company I founded, ITXC, had a successful IPO in 1999.  The stock more than doubled from the offering price in the first day.  At some point the underwrites exercised their option.  The company got some more money and the underwriters made more.

But, right now, Vonage stock is going down, not up.  And the over-allotment still may be worth a lot of money to the banks.

In 2000 ITXC had  a secondary offering at about $86 share.  As it turned out, the secondary closed on the day that NASDAQ peaked.  The stock was up for a day or two and then down with the rest of the market.  The bankers didn’t exercise the over-allotment; that is, they didn’t buy any more stock from the company; but they were still in a position to benefit from it.

I’m writing from my experience in Bubble 1.0 so it is possible that things have changed.  However, here’s how it worked.  Often the offering banks sold not only the shares officially offered in the IPO – 31,250,000 shares in the case of Vonage – but also sold the shares they had a right to acquire though over-allotment – all on opening day or soon thereafter.  This is a short sale since the banks don’t actually have the over-allotment shares yet.  But, unlike most short sales, the banks know they won’t lose if the stock goes up because they can always buy the stock to cover the short at the offering price.

So suppose the banks sold the Vonage over-allotment short on IPO day – note that I do NOT know whether or not they did this nor even how to find out.  They would have received almost $80 million for these shares including commissions.  Since they haven’t exercised the over-allotment, just sold the shares which it represents, none of this money goes to the company.

Suppose also that Vonage, instead of going back up continues down, perhaps to $10/share.  The banks can then buy the shares they sold short on the open market for $10 each.  In this case they obviously won’t exercise their option to buy at $17 and the company won’t raise any additional money.  Profit to the banks on the short sale would then be $7/share for a total of $32,812,500.00.  The lower the price of Vonage goes, the more profitable the riskless short sale is to the banks.

I don’t think there is a way to for the bank to both keep the upside potential of the over-allotment AND do the short sale.  They do have to make a choice at some point.  Again, I don’t know what Vonage’s banks did. Either on the upside or the downside, however, the over-allotment can be huge source of bank profit beyond the commission.

It’s all legal.  It’s disclosed right there in the prospectus.  You just have to understand what the over-allotment is and what it means.

Fictional CEO Larry Lazard in my novel hackoff.com: an historic murder mystery set in the Internet bubble and rubble got burned by not understanding how a green shoe might work.  He wasn’t happy.  But fictional trader Sam Gutfreund at fictional bank Barcourt & Brotherson was.  You can read that episode free if you’d like.

Hat-tip to reader Ellen S who told me that the term “green shoe” originated with the IPO of the Green Shoe Company.

You Always Bet the Company

Fred Wilson blogged about “betting the company.”  Great post but, I think, he was only two-thirds right.

“…in a venture stage business,” says Fred, “you should be betting the company every day.” Certainly right.

Fred also says “I think this is why many (most?) big company managers fail as venture stage CEOs.  They are taught to mitigate risks, to plan, to protect. They don’t want to fail and so they do.” Also right.

But, IMHO, Fred is wrong when he says “if you are running a Fortune 500 company, betting the company is probably not something you want to be doing.”

AT&T was unwilling to bet the company on the Internet or on many of the different futures would have saved it.  So AT&T lost almost all of its value and became the junior partner in at&t.

American automakers have been unwilling to bet the company on either new methods of production or significantly more energy-efficient product or other disruptive change.  They may well be losing their companies.

Microsoft bet the company many times: two examples are on its partnership with IBM (and its own ability to be the winning partner) and on Windows.  I left Microsoft partly because of a disagreement with Bill Gates over how soon Microsoft should bet the company on the Internet.  But the argument was over whether and not when.  There was no disagreement over whether it was appropriate to be the company.  Bill knew then that it was and probably still does.

Steve Jobs bet Apple on the Mac.  He was right.  His successors were market-extenders; they didn’t bet the company.  They damned near lost it.  Board had to bring Steve back to start betting the company again.

You’re not always right when you bet the company.  Scott McNealy bet Sun on the SPARC processor and his vision of network computing.  Close to lost the company.  Maybe did in the long term.

United Airlines never seemed to recover from the Alegis travel mashup fiasco.  Might have been in trouble anyway, though.

Many companies were bet and lost on the long-term value of data transmission facilities.

I bet Solutions, a private software company, on the continued success of the Mac just as Apple went into a decline and a workable version of Windows came lumbering along.  Wrong call. Ended up selling most of the assets of the company to Microsoft for much less than I’d been offered a year or two earlier. (not their fault, mine.  We were glad to have them as an exit and I ended up going with the assets to Microsoft.)

The point is, if you’re the one who makes strategic decisions, you’re betting the company every day whether you choose to acknowledge that you’re putting the chips down or not.  Doing nothing is a bet on the status quo.  Usually that’s the wrong bet in the long term but it’s an easy one to sell in the short term since you don’t appear to be making a bet at all.

It’s harder to bet the company when the company is public.  One of the reasons why it was a bad thing that so many venture stage companies ended up prematurely public in Bubble 1.0.  But, public or not, you’re betting the company every day.  I did that with more gusto when ITXC – a company Mary and I founded – was private.  But I regret not having maintained that gusto for betting the company even when much less of it was mine.  Could have lost as well as won spectacularly, of course; but that’s what CEO’s are paid to do.

Fictional CEO Larry Lazard in my novel hackoff.com had a revolver on his board room table. When decision time came, he’d spin the cylinder, put the barrel to his head, and say “I bet my life.” Since he didn’t keep the gun loaded, he meant he was betting the company. In his case, though, it was that gun that shot him (it’s a mystery so I’m not gonna tell you in whose hand the gun at the time).

If you’re a CEO – no matter what size your company – ask yourself each morning when you brush your teeth what you’re betting your company on.  If the answer is “nothing”, it means you’re betting on the status quo without even making that decision explicitly.  Very bad idea.  Not why you get the big bucks.

I blogged about AT&T managing for quarterly results rather than betting the company in the Lessons from the Crypt series which starts here.

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hackoff.com: An historic murder mystery set in the Internet bubble and rubble

CEO Tom Evslin's insider account of the Internet bubble and its aftermath. "This novel is a surveillance video of the seeds of the current economic collapse."

The Interpreter's Tale

Hacker Dom Montain is in Barcelona in Evslin's Kindle-edition long short story. Why? and why are the pickpockets stealing mobile phones?

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