Importance of Corporate Governance

As we get closer to SEC's final ruling on equity crowdfunding, I think it is important to have some sort of corporate governance in place whenever a startup seeks funding from investors. It is more important than limiting an individual's contribution on capital. VC backed firms have it in their term sheets on how the startup will be governed such as who will sit on the board, how the funds will be used, and how the progress of the project will be tracked.

Since a large sum of money is at stake here, the backer and the founders meet frequently and the budget gets tweaked quite often as the funding need changes over time. The more real time and transparent the monitoring becomes, the more certainty there is that the business is not misusing the funds.

My concern with the direction of where the SEC is going with equity crowdfunding regulation is that they are missing the mark on where the regulation should be. I have not seen any language referencing corporate governance on their proposed ruling.

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Equity Crowd-Funding

As an investor, I come across several people seeking to get funding for their ideas or business.  Some of them have already sought funding through crowd-funding portals such as Kickstarter or Indiegogo without having to give up equity in the company but are still in need of additional funds.  Others have grown organically and are generating revenue but are also in need of additional funding in order to take their business to the next level.  

However, not all of these great ideas and/or business concepts will get funded through traditional means of investing such as venture capital or an angel investor.  The reason being is simple.   Investors in startups acknowledges the risk involved and the low probability of success.  In order to mitigate the risk, the investor has to mitigate it in two ways.  First, diversify the investment portfolio by planting the seed in several different kinds of startups.  There is no way of knowing for sure which ones will flop, which ones will get sold to Google, and which ones will become the next Google.  

Second, make sure that there are enough influx of cash to capture market share and/or to keep the traction alive.  To the second point, it is the difference between an indie film and a Hollywood film.  Certainly one is not necessarily better than the other, but the films made in Hollywood have the marketing dollars to reach out to the vast majority of audiences.  This same principle applies to startups.  

Also given the high degree of risk, the investments has to yield a high degree of reward.  Sure, there are businesses that never breaks above a $100K in revenue but still manages to survive for a long periods of time. However, where would the return on investment be when hundreds of millions of dollars has been invested in a portfolio of successes and failures.  For venture capitalists and angel investors alike the successful company has to yield enough return to cover the losses of the failed ones.  So, where can these businesses with a decent idea that may not generate astronomical returns go for funding? The answer to this conundrum can be found through equity crowd-funding.  

Equity Crowd-Funding portals can be both a blessing and disruption to VCs and angel investors.  There are ideas out there that are too far fetched and possibly born way before its time that gets easily passed up.  These ideas gets passed up because there are no relative comparable to assess the risk of the enterprise.  There are other ideas where the management team is too inexperienced and untested to just write a check.   The risk here is that they may present an idea that looks good on paper but may not be able to fulfill on the promise of making it possible.  For example, a great medical technology that promises to replace the harmful radiation of x-rays.  

What equity crowdfunding can do for VCs and Angels, me included is to screen out the bad from the good.  It also allows an unproven entrepreneur to showcase his or her capabilities to bigger investors.  For the equity crowdfunders, the loss from investing in such enterprise will not be so bad due to the small amounts of money that an individual is investing.  The best outcome for crowdfunders should be to limit the total pot of money to the amount they feel comfortable donating without getting anything in return.  Otherwise, it would be no different than playing the odds at Vegas.  

Personally, I am for crowdfunding and crowdfunding for the little guys who can only invest a couple of grand.  I also understand the opportunity cost this will cause for a traditional investor of this space, especially if the very successful enterprise gets enough money through crowd source and does not need it from us.  But overall, entrepreneurship is the new revolution and how big or small the enterprise, they all need a fighting chance.   

 

Innovation Through Studying Abroad

This was post that I posted on my mother's site as a guest post.  

You can visit her site at atozuhak.com

You can also visit her personal blog on uhakmom.com.  Warning, it is mostly written in Korean. 

The mantra in the business world is now, “Innovate or Die!”

The same goes for individuals as well.  We must all constantly innovate by improving ourselves and everything around us.  We must keep pace with the ever-changing global economy.  We are now living in the forefront of a technological revolution.  Although technology is making it easier for us to become more efficient and achieve more than we could have ever imagined, the technological revolution also means disruption to our traditional ways of thinking.  

We can no longer be confined to the comfort of the our own self-made circumstances.  The traditional ways of achievement to success is no longer a viable option for us to get ahead in this world.  This also means that the traditional educational route that everyone else is taking is actually hindering their full potential for creativity, problem-solving skills, and inspiration (the formula that leads towards innovation).  


To solve this conundrum, we need to break out of the mold that restricts us from reaching our fullest potential.  This means taking the necessary risks to explore the worlds unfamiliar to us.  My Alma Mater, NYU, has encouraged global education. From the first year to the last, they encourage their students to study abroad.  They have set up several study abroad locations such as NYU in London, NYU in Shanghai, and most recently, NYU in Abu Dhabi just name a few.  My experience in NYU in Shanghai was the most memorable.  Shanghai is at the forefront of becoming a major city, if it has not already.  It is a city sought after by several global enterprises.  A section of Shanghai, known as Pu-dong, is dominated with multi ethnic people and culture that spurs creativity.  I also had the privilege to work for one of Shanghai’s prestigious venture capital firm specializing in mobile technology, which even enhanced the experience.     

Interestingly enough, for the students living and studying in Shanghai, their spark of creativity are formed by studying in the United States as a foreign student or as an exchange student.  The current phenomena for the Chinese is to study in the United States and take creativity and inspiration back to their country.  Just as Shanghai was an eye opening revelation for me, the United States was also an eye opening revelation for them.  In the end, what eventually sparked creativity, problem-solving skills, and inspiration was in exploring the unknown and breaking out of their current normal.  


Skype/MS Deal Justified

In my previous posts, I mentioned how social media companies such as Facebook and Linkedin comes with a huge price tag well above its fair value based on what investors are willing to fork up for them on the secondary markets. This exuberance extends well beyond social media companies onto other technology companies as well. However, fair value is measured differently among various investor classes. Based on current valuation, Facebook and Linkedin maybe overvalued for individual investors looking to buy and hold them for a period of time but for other strategic investors, it may not be so....

Bubble? The Institutional Investor Advantage

In my previous posts, I have indicated that Linkedin and Facebook trading in the secondary markets are overvalued based on fundamentals. This reasoning extends beyond these two companies and into other social media companies just making it into the mainstream. However, we have to treat the future valuation of these companies slightly different from publicly traded ones. Hence, a few players overpaying for current piece of the company does not necessarily mean the whole industry is in the bubble mode. Bubbles will eventually form in the social media arena for it is inevitable for a new economy to arise while weeding out the weak. That is exactly what the tech bubble of the late 90s did for us. Out of the tech bubble companies such as Amazon came out stronger and more valuable redefining how books are sold after suffering a set back as result of overvaluation created by the market. Nevertheless, right now...

American "Noblesse Oblige"

In America, we dwell in the comfort of our circumstances. With a current GDP per capita of $46,000, we are considered to be one of the richest nations in the world. A vast majority of the people own cars or have access to public transportation. Almost everyone owns a mobile phone with some sort of Internet connectivity. Even in the poorest neighborhoods, people are able to afford to have a television in the living room. By any measures, we are considered nobles and must adhere to what the French coined as “noblesse oblige”, which simply means the obligations of the nobles. As a wealthy nation, we have an obligation to...

Is Facebook Overvalued?

Facebook has last reported to trade on the secondary market at 75 Billion Dollars, which is trading at 35 times the last reported revenue of 2 Billion Dollars.  To better understand the valuation, we will compare it to Google at its IPO.  Like Facebook, Google’s revenue has double almost every year growing up to 1.4 Billion for its first half of the fiscal year leading up to its IPO in August 2004.  I was at Morgan Stanley at the time and even my colleagues were divided on whether the Post IPO market pricing after the auction was a result of media hype or from true fundamentals.  At the time of Google’s IPO, the initial market cap was at 23 Billion Dollars, trading at about 7 times the year end 2004 revenue and 58 times the earnings.  Even at the height 2005 when Google was trading at $430 per share, it was only trading at 21 times the revenue and that is even after their margins drastically improved.  Here is closer look at the comparison points.

 

 

Linkedin IPO will give us a better understanding of where Social Media headed

Secondary market trading for Social Media suggests that these companies are overvalued.  Facebook with last reported revenue of 2 Billion Dollars is trading in the secondary market at a valuation of $75 Billion Dollars. That is 35 x revenue and we have no idea how many times earnings its trading.  However, Linkedin with 90 million users in over 200 countries is valued on the secondary market at around 2.5 Billion Dollars and is set to go public sometime this year.  They reported a nine months ending 2010 revenue of 161 million dollars and net earnings of 10 million dollars.  Compared to Facebook’s 35 times revenue, Linkedin is currently valued at 16 times the revenue and 250 times the earnings. 

Linkedin is one of the popular social media sites and has three streams of revenue income.  The revenue sources are from Hiring Solutions, which makes up 41% of total revenue, Marketing Solutions, which makes up about 32% of total revenue and the remaining 27% is from Premium Subscriptions.  This suggests the bulk of their revenue is coming from Hiring Solutions and may continue to do so going forward.  Furthermore, according to the Company’s S-1 filing, 2010 was their first profitable year.  Given these numbers, the valuation at 2.5 Billion is too large to justify.  Even with the most optimistic Price to Earnings Growth forecast, I am giving it 800 Million Dollars at most.  

Moreover, as the jobs market continue to improve; I don’t foresee the same level of growth continuing for the Hiring Solutions side of the business.   Although I use Linkedin to stay connected with professionals in my network and to source for future deals, I personally have not used and do not foresee myself using the subscription services in the near future.  The only sustainable model for continual high growth is the Marketing side of the business as advertisers continue to target professionals categorized by industries.   

However, Linkedin IPO will tell us whether the hype in social media will continue or if it will be a timely exit for the VCs heavily invested in these companies.  What the market has taught me in the last ten years is that we have to switch back and forth between fundamental and behavioral finance.   Remember back in 1995 when the Dot Coms were overvalued?  Well, the true fundamentalist missed out on the next four years gain.  

Which types of Start-Ups are allowed to have Negative Cash Flows from Operations?

There is a time and place for capital injection for startups making no revenue with zero equity.  Most entrepreneurs believe that if they concentrate on building and perfecting their products and/or services, large sums of money will automatically start trickling in.   Although some start-ups may get capital injection from investors at the seed stage, it is not typical.  Most start-ups need to make money from day one and may never see external financing other than the line of credit from their bank.  Others may not even have such luxury and may need to resort to bootstrapping and maximizing all of their personal credit cards.   There are basically two types of start-ups of which deserve different treatment in its early stages. 

 

The first types of start-ups are e-commerce, brick & mortar retail stores, and consulting/professional services, practically majority of the business in existence.  These types of start-ups need to have positive free cash flows from operations in order to fund the continuing operations of the business.  Holy grails of these businesses are ones that have either negative or zero cash flows from financing.  That is, the business can survive without having external financiers. 

 

The next type of start-ups are those that are launching innovative products and/or services.  Think newly formed drug companies with a patent on a drug or a software companies with an innovative product that will soon launch to market.  A negative cash flow from operations for these types of business is acceptable.  That is, they may fund the operation from financing activities.  The only main criterion is that the internal rates of return have to be positive.  If the internal rates of return from R&D expenses are deemed to be positive, then it will only make sense for the business to seek external financing for their business.  However, the question than becomes, which products or services are considered to have positive internal rates of return and what type of business are considered innovative products and/or services?

 

To answer the first question, the product or service has to be innovative enough to withstand on its own and generate astronomical rates of return by capturing a large percentage of the market.  For example, if the product is a prescription drug that can potentially cure terminal cancer, the demand for such product is definitely there.  It may just need to complete the clinical trial phase and gain FDA approval before it can come to market.  This would mean the business would not generate any revenue until the clinical trial phase ends and the drug gets approval from the FDA.  Until that happens, the start-up will need some sort of capital injection in order to bring to market.  The capital injection at this point needs to be large enough to create a buzz in the market.  That is, when people refer to a drug that cures cancer, they will think of that particular drug.  The reason for this is simple.  If the drug gains popularity but fails to capture a large market presence, there will be copycat firms coming out with similar products and they may corner the market instead.

 

To answer which start-ups are considered innovative think of Picasso, Da Vinci, and Polack.  They were considered the greatest artists of their time because they brought to the art world a new medium, becoming the pioneers of their styles.  Others have followed suit, but when one thinks of cubism, they quickly point to Picasso.  In essence, for a start-up to be truly innovative, the product or services has to be something that the markets wants but hasn’t realized yet.  In the course of a day, I come across several start-ups telling me why they are different.  In reality, however, they are the same service or product that is already in the marketplace but with a little twist to it.  For example, almost every other start-up that I come across is some sort of social media that does not make any revenue.  The first question that I ask is how they will generate revenue and the typical answer that I get back is nothing more than having a glorified website that may or may not attract traffic.  If that is the case, their business is more like the first type of start-up and needs to make money from day one in order to survive.