Apple watch underwhelms. Another Hype over Fact example

One downside of a swirling, Twitter-fed, Facebook-liked echo chamber is the increased frequency of Hype overwhelming Fact.

Hype is when people collectively believe something yet the underlying Facts belay that belief. A few examples:

• Justin Bieber is the greatest performer of our era
• Lance Armstrong is an American hero
• Uber is worth $40 billion
• The Apple Watch changes everything.  It’s the next big thing.

Turns out, none of those appear to be true.  Bieber’s 15 minutes is over, Lance is actually complaining that athletes in this year’s tour might be doping, and we’ll see if Uber grows into it’s valuation.  Then, there is the Apple Watch.

Apple has yet to announce sales numbers for their Apple Watch, and rumors of higher returns and falling sales have led the Hyped to simply lower expectations.  There’s a great in depth blog on it here, if you’re curious.

I receive a daily feed of venture-backed companies whose financings are announced that day.  It is breathtaking the amount of money that is going into business whose potential for exit are modest.  Or, I guess I should say, the investment thesis is predicated on virtually everything going right.  Everything never goes exactly right.

Edward Chancellor, in his excellent book “Devil Take the Hindmost” describes the psychology of market bubbles, from the Dutch Tulip bubble to the internet crash.  Hype has ever been with us, including the 1830’s railroad bubble, when the cumulative valuation of all railroad startups exceeded the size of US GDP.

So, let’s not give in to the mass hysteria, folks.  For me, there is one clear takeaway from Chancellor’s book:

If you hear “this changes everything”, it’s time to head for the exits.

Reddit’s easy fix

Are you following the hand wringing over Reddit? If not, the problem is that a few people say terrible things there. And then Reddit tries to figure out how to stop it without infringing on the sense of ownership that users have for the content they help create. But deciding where the lines are and what crosses the lines is hard. After all, Google links to ALL SORTS of terrible things (seriously, click on that link at your peril), but since they don’t host all that terribleness, it’s all OK.

The controversial CEO Ellen Pao has left, and people are clamouring for “real leadership”.  This is not a “leadership” problem any more than global warming is a “sunshine” problem.

Rob Labatt and I have been discussing Reddit’s dilemma, mainly because we’ve lived through it.  Rob was CEO of a company called ezBoard, where I invested.  ezBoard grew to be a giant host of discussions of all kinds, circa 2000-2008.  We had the exact same problem as Reddit, and struggled over it in the exact same way (minus blaming the CEO — Rob was great).  The challenge is less about leadership and more about the nature of online communities.  They are, let me not say “unruly”, let me say “heterogenous”.

And, beyond attempts to play moral policeman, it’s also hard to get advertising dollars for a website that has folks saying things with which Safeway or Ford Motor Company would rather not have their names associated.

GOOD NEWS:  There is an easy fix.  The easy fix will temporarily reduce some of Reddit’s traffic but shine a fantastic light on the shady neighborhoods, and it’s this—

Make Reddit users use their real names.

It’s far easier for bad behavior to hide behind anonymity, that’s why mobs can be so destructive.  That’s why the Ku Klux Klan wear hoods.

Facebook, the most successful social network in the world, requires the use of real names.  I have a friend who is working to legally change her name, but until she does, Facebook won’t let her use the name by which everyone knows her.  So it can certainly be done.

Then, the people who need to hide behind anonymity will go to some other site that allows for that sort of thing, and we can campaign to root them out from there as well.  Keep Reddit to its original theme of Democracy Re-envisioned.  Well functioning democracies require ID for voter registration, so Reddit should take a hint.

And it removes much of the problem without Reddit trying to play policeman.  There will still be occasions where Reddit will have to remove content, but I guarantee those occasions will be drastically reduced.  Real names is the single biggest change to allow Reddit to move on from this series of bad PR and destructive moves.

Too many convertible debt rounds

This for my venture capital readers: Convertible debt is being used for too many financings.

For non-VC readers, an aside.  Convertible debt is like a loan to a start-up company while they prepare for a traditional “investment round” which is when the investor purchases equity shares in the company.  The convertible debt “converts” into equity when that traditional round comes along.

Got it?  Wait, there’s more!  The convertible debt has a “cap” on what price it will convert to in a financing, and there is sometimes a discount of 15% to 25% as a small financial benefit to the debt holder.  In an “investment round” the equity purchased by investors is “preferred” rather than “common” stock which includes a whole slew of financial advantages (paid first in a sale, can participate in the next financing round), control advantages (board seats and voting rights), and exit freedom (influence on the type and price of exit or financing).

There should be an entire series of posts on those things, so stay tuned for when I get around to that.

OK, I understand the allure of convertible debt for entrepreneurs, they get to do a rolling close (raise money as they go rather than wait for the entire target amount), set their own price (via the cap and discount), and have low legal fees. But as convertible debt rounds increase to be the size of Series A rounds from three years ago, it’s gone too far.

Here is what you, dear investor, are investing in with your millions:

1) No board seat
2) No control provisions
3) No pro-rata in the next round of financing.
4) The 15% discount is not representative of the risk or progress made, particularly when the cash will last the company a year.  To wit:  who believes the company is only worth 15% more after a year?  If you believed that, you should not have made the investment.
5) no start to the timer for tax rollovers for small business investments after 5 years (effectively, a 30% impact on your exit value)

And you, entrepreneur, are missing out on a few things as well:

1) a down round after taking debt is like “full ratchet” anti-dilution, meaning 100% of the down pricing is suffered by entrepreneurs, not investors.  While you believe your success is always up and to the right, that belief might be because you haven’t lived through the last two venture industry downturns.  We have one about every 8 years, which means it’s time for the next one.
2) possibility of friends and family in convertible debt getting screwed by the preferred investors, since the debt has no control over financing.  Then they don’t trust you, and you don’t get to start another company if this one goes bad (which odds are, it will)

These thoughts have been building for a time, but came to a head after reading Brad Feld’s complaints about an investment made by VCs after Brad’s seed investment.  You can glance at that here.

While it might not be the best practice for VCs to step on their fellow VCs toes, Brad’s complaint is, really, that he’s using a tool that doesn’t protect him, and that’s the reason that Series financings have been developed over the last 50 years.  The standard terms in preferred stock investments have been honed over those 50 years, and incorporate all the protections created after bad actors did bad things over 5 decades.

What surprises me, though, is that abuses don’t happen more.  Give enough people $2 million at a time with no constraints, and some portion of them will buy new cars or  throw a party featuring the Dixie Chicks.