The Smart Person Fallacy In Two Easy Steps

April 20, 2014 / / No Comments

The Smart Person Fallacy in two easy steps. “I’m smart, I can learn about situation X and figure out the way it should work.”

First step: Situation X is likely far more complex with far more moving parts and confused causes and effects than you can imagine. Autodidacts and polymaths are highly prone to this. True experts in a field are often far more skeptical about their own ability to understand. Often suffered by professional writers, journalists, commentators, columnists, analysts, investors and venture capitalists.

Second step: In many complex situations, logic matters far less than other factors — with incentives at the top of the list. So thinking your way to the answer may well be counterproductive or worse. Often suffered by intellectuals, academics, theorists, paternalistic left-wingers and venture capitalists.

Bonus step: For any mandated change to situation X, unintended consequences are likely to dominate the long term effects.

Source Tweets: 1,2,3,4,5,6,7,8

Private Valuations In Tech

April 17, 2014 / / No Comments

The third aspect of the valuation of tech companies often misunderstood is private valuations set by venture capitalists and other private investors. This topic was recently explored by @Jessicalessin in this excellent article.

A private company in which a sophisticated investor has bought a minority stake for $X/share is not actually worth $X * total number of shares.

First, the entire company has not traded hands, just a small slice of it. So we don’t actually know what the whole company is worth. Second, most financing rounds are for preferred shares, which have special rights. Other shares don’t have those rights and are worth less. Smart VCs think about startup shares less as stock than as options — options with limited (1x) downside and unlimited (1,000x+) upside.

A share of preferred startup stock ~= A long-dated out-of-the-money call option, paired with a long-dated contingent put option. The contingent put option is the liquidation preference in preferred stock. It increases the odds of getting cash back in a downside sale of the company. Plus, in some high-valuation late-stage rounds, there are additional downside protections like ratchets, which can be highly valuable and preferred stock brings with it governance rights and access to information not available to normal investors. Those have value too.

So you can’t extrapolate the value of an entire company from a minority sale of preferred stock. It’s better just to focus on cash raised. In my view, there is WAY too much discussion of private valuations in tech. Fuzzy numbers matter way less than real company substance.

The best book to read as a followup to this post is Venture Deals: Be Smarter Than Your Lawyer and Venture Capitalist by Brad Feld.

https://twitter.com/pmarca/status/457023178598907904
https://twitter.com/pmarca/status/457023859477053440

Source Tweets: 1,2,3,4,5,6,7,8,9,10,11,12,13

Common Fallacies About The Valuation Of Public and Private Technology Companies

April 17, 2014 / / No Comments

First, ask any MBA how to value tech companies, she’ll say “discounted cash flow, just like any other company”.

Problem: For new and rapidly growing tech companies, up to 100% of value is in terminal value 10+ years out, so the discounted cash flow framework collapses. You can run as many discount cash flow spreadsheets as you want and may get nothing that will help you make good tech investment decisions. Related to the fact that tech companies don’t have stable products like soup or brick companies; future cash flows will come from future products. Instead, the smart tech investor thinks about:

  • Future product roadmap/oppurtunity
  • Bottoms-up market size and growth
  • Talent and skill of the team.

Essentially you are valuing things that have not yet happened and the likelihood of the CEO and team being able to make them happen. Finance people find this appalling, but investors who do this well can make a lot of money, but spreadsheet investing is often disastrous. It doesn’t mean cash flow doesn’t matter, in fact the opposite is true: this is the path to find tech companies that will generate tons of future cash.

Corollary: For tech companies, current cash flow is usually useless for forecasting future cash flow, a lagging not leading indicator. This trips up value investors (Prem Watsa!) all the time; tech companies with high cash flows often about to fall off a cliff. Because current cash flows are based on past products not future products and profitability often breeds complacence and bureaucracy.

Always, always, always, the substance is what matters: WHO and WHAT. WHO’s building the products and WHAT products are they building?

Brand will not save you, marketing will not save you, channels will not save you, account control will not save you. It’s the products. Which goes right back to the start: Who are the people, what are the products, and how big is the market? That’s the formula.

https://twitter.com/PGuru714/status/456683768841904128

Source Tweets: 1,2,3,4,5,6,7,8,9,10,11,12,13,14,15

Tech Valuations and Attach Rate

April 17, 2014 / / No Comments

The second thing often misunderstood about tech valuations: How M&A acquirers decide how much money to pay for companies they buy. The key: The value of a tech company to public or private markets may be completely unrelated to the value of the same company to a corporate acquirer. Value of company X to acquirer Y often = Potential impact to acquirer Y’s business, which has a lot more to do with Y than X.

For example, in product businesses, you’ll often hear the term “attach rate” — acquirer Y can attach company X’s product to Y’s sales engine. Example: I sell $20B of servers/year; I buy storage company X doing $100M revenue/year; and I can attach X’s product to 20% of my server sales. I can generate new $20B*20% = $4B/year of storage sales attached to my server business. X’s standalone revenue is irrelevant. So I can pay up for storage company X based on its projected impact on MY business, way beyond X’s independent valuation.

Of course, for the deal to be good, I have to deliver that attach rate. But when it works, and it often does, it’s magical and worth doing. This is the literal meaning of attach rate, but there are other, such as, maybe I know how to better monetize something I buy than they do.

Large dollar acquisitions of small companies that seem irrational to outsiders almost always have a rigorous plan like this within the acquirer. It’s just nearly impossible to see from the outside, which is why many outsiders get so confused and upset at the time of acquisition.

But, on the other hand, we do not consider it safe for a tech startup to have a plan that DEPENDS on a large acquirer applying this logic. We only invest in startups that have a plan to be large independent dominant companies on their own, with great businesses in the long term. And the act of building for long-term independence makes you more attractive to potential acquirers, not less. So you can win both ways.

Source: Tweets – 1,2,3,4,5,6,7,8,9,10,11,12,13,14

Responses:

Follow Up: Current Information On Large Capital Technology Valuations

April 15, 2014 / / No Comments

Following up on the earlier post on new tech growth company valuations, here’s some current information on large cap tech valuations.

Since some big tech companies now have gargantuan cash reserves. I like to look at the Price/Earnings ratios adjusted for cash on balance sheet.

Apple, the shining jewel of American capitalism, has chinned all the way up to the 2014 estimated Price/Earnings ex-cash of 11.2. Google, the company everyone agrees is the General Electric of the 21st century: 2014 Price/Earnings ex-cash of 19.4. Big legacy tech foursome 2014 Price/Earnings ex-cash: Oracle 12.6, IBM 11.1, Microsoft 10.7, Cisco 9.5.

These are still so low as to qualify as generational lows. Public tech Price/Earnings haven’t traded this low, for this long, since the 1970s. I’ve said it before and I’ll stay it again: If this is a new tech bubble, it’s managing to bypass all of the big public tech companies. So to rationalize all of this, you pretty much have to believe one of three things:

  1. This is the weirdest equity bubble ever. It ignores the large capital companies that are easy to trade which is not what happened in the late 90’s.
  2. The public market is still scarred after the 2000 and 2008 crashes, hates tech equities, except a handful of companies delivering rare growth.
  3. Many large-capital technology companies are in dire trouble. They are about to be taken apart by a new generation of disruptive challengers.

Source Tweets: 1,2,3,4,5,6,7,8,9,10,11,12

Data On The Recent Stockmarket Downdraft

April 14, 2014 / / No Comments

Some data on the recent stock market downdraft, assembled by my partner @skupor.

For the seven top consumer tech stocks (FB, TWTR, ZU, TSLA, LNKD, P, YELP): the median is off -37.4% from highs. For four of the top enterprise tech stocks (WDAY, SPLK, FEYE, NOW): the median is off 42.0% from highs. NASDAQ overall is off -8.5% from its high. Google is off -12.4% from its high; Netflix is off -27.8% from its high. Tech IPOs in 2014 so far; the median is off -22.0% from high but up 0.3% from the offering price (equals effectively flat to offering price).

People who want to see a tech bubble look at this data and say, “See! I told you it was a bubble, and now it’s crashing.” People who don’t want to see a tech bubble look at this data and say, “See! I told you it’s not a bubble; the market mostly still hates tech.” One cautionary note: This kind of market behavior with big up and down swings often correlates to high short activity.

https://twitter.com/oakpassrd/status/455771311403327488

When shorts take a big position, stocks fall. When shorts liquidate, stocks rise. When shorts are squeezed out, stocks really rise. It can be tricky to try to divine where the market wants the price to settle in the middle of a vigorous long/short battle, like arguably now.

https://twitter.com/perryrahbar/status/455774938168033281

Source Tweets: 1,2,3,4,5,6,7,8,9,10

The Hypothesized Corrosive Influence Of Money On Politics

April 5, 2014 / / 7 Comments

Saturday’s thought experiment: Thinking about the hypothesized corrosive influence of money on politics. Let’s take as a given that income inequality is high and rising. Most people have less money than some people (99/1 or 90/10 or something). Let’s also take as a given that the mechanism of money corroding politics equals campaign donations or advertising, mainly TV commercials.

The presumption is that rich people donate money to candidates who run TV commercials to persuade poor people to vote against their own interests. This despite the fact that poor people outnumber rich people and each person can only vote once. Poor people numerically dominate voting. We assume TV ads funded by campaign money from rich people actually convince poor people to vote against their own interests. But do they?

How do we tell the difference between poor people getting fooled into voting against their own interests versus poor people voting how they want? To believe money has corrosive influence on politics through this mechanism, must we believe that poor people are stupid?

Alternate explanation: Poor people vote how they want, other people don’t approve of their choices, and rich people are wasting their money? How can we tell? Short of assuming that our judgment of how poor people should vote versus how they do vote is prima facie correct?

Meanwhile, how do we feel about people who make top-down judgments about poor people in other political and economic contexts? If one believes poor people are too stupid to vote in their own best interests, in what other areas must they also be judged as stupid?

In case it’s not obvious: I think poor people (and middle-class people) are smarter than many observers and activists think. I say that having grown up in the rural lower-middle-class myself. Poor and middle-class people are frequently patronized.

I think in many areas of policy we have concluded that poor people need to be protected from themselves; I think this is dangerous.

https://twitter.com/matthewhummel/status/452505064276754432

Source Tweets: 1,2,3,4,5,6,7,8,9,10,11,12,13,14,15

Two Quick Brendan Eich Stories

April 4, 2014 / / 1 Comment

Brendan was one of the very first Netscape engineers, joined from Microunity, a famous venture-backed chip startup fiasco at that time. We decided we needed a scripting language for web browsers and web servers. We investigated every option. Brendan said, I can build one.

He single-handedly wrote Livescript (the first version) in three months. He built it into the browser. He created modern web programming and borrowed Java syntax. Sun asked us to embed their new Java into browser; in return we forced them to accept the name “Javascript” for Livescript. They hated that!

At the time, I thought Java would dominate client and Javascript would dominate server; it turned out the reverse happened for 10+ years. Javascript in the browser became BY FAR the most widely used programming language in human history. This is a breathtaking achievement. Beyond amazing.

Years later, after Netscape/AOL and AOL/TimeWarner mergers, Brendan called me to see if I could help free Mozilla into a nonprofit. I called Jim Barksdale who was on the AOL-TW board. With Jim’s help, Mitchell Baker and Brendan successfully established the Mozilla Foundation. This was an unnatural act for a big company and could have easily not happened. Mitchell and Brendan made it happen and redefined the web again.

So, if you like your browser, your Firefox, and/or your Javascript, whatever your political beliefs, you owe Brendan a debt of gratitude. The web would be a sparse and barren place without Brendan’s work. I can’t argue with his decision, but I can’t wait to see what he does next.

Source: Tweets – 1,2,3,4,5,6,7,8,9,10,11,12

How To Kill The Public Stock Market In 8 Steps

March 31, 2014 / / No Comments

How to kill the public stock market.

Step 1: The number of public companies naturally shrinks each year due to mergers, takeovers, and bankruptcies.

Step 2: Use regulatory “reforms” to radically reduce the rate of new IPOs, shrinking the number of public companies from 8,800 to 3,600 since 1997.

Step 3: Steadily increase the number of regulators, lawyers, activists, pressure groups, and “governance experts” against the shrinking number of public companies.

Step 4: The “Pounds per square inch” of pressure on each public company increases, further disincenting new IPOs and incenting private takeovers.

https://twitter.com/fmbutt/status/450660479359131648

Step 5: Private growth companies go public much later or not at all, shifting growth and capital gains from the public to the private market.

Step 6: Without growth, it gets harder and harder to realize the gains in the public market required by investors, particularly for retirement plans.

https://twitter.com/pmarca/status/450662133173194753

Step 7: Layer on top a healthy dose of market manipulation, mutual fund front-running, and HFT profit extraction.

Step 8: Repeat as necessary until the blood is completely squeezed from stone, then wonder what happened to the good old days.

Source Tweets: 1,2,3,4,5,6,7,8

Critiquing Tech

March 26, 2014 / / No Comments

A common critique of new tech from outsiders is “Yes, sure, it’s great tech, but it will never have practical value or usefulness.” I think that is almost always a form of fake sophistication. It sounds sophisticated but it’s not. It’s a hat tap followed by a slam.

Yes, sure, the automobile is great tech, but it’s not like normal people are going to use it to get from point A to point B.

Yes, sure, the television is great tech, but it’s not like normal people are ever going to prefer it to a good stage play.

Yes, sure, the refrigerator is great tech, but it’s not like you’d ever actually store your meat in it.

As such, this critique is usually what theoretical physicist Wolfgang Pauli called “not even wrong”. There’s no logical substance or flow. When techies critique tech, it’s more: “This new tech is interesting, but it’s missing properties X, Y, and Z to be used in that way.” That critique can be either right or wrong, and vigorous debate follows. That’s how a lot of technological progress is made. Hence, from the structure of the critique, you can often inductively determine the qualifications of the critic to make the critique.

Source Tweets: 1,2,3,4,5,6,7,8,9