Economies of Small

I’m working on a book, tentatively titled “Economies of Small:  What large organizations can learn from small organizations”.  My agent has said the title will have to change, and I’ll give a free T-shirt to the best idea if we use it.  Here is the teaser text:

Your job is bizarre and you know it.  It’s complete with political maneuvering more akin to the UN, cash decisions that you wouldn’t allow your teenager to make, and a cubicle too small for your pet.

How did we get here? How did we end up where businesses in a great nation (representing 25% of the world’s economic output) are run like the French World Cup soccer team?

And how can we get somewhere else more successful and rewarding?

Economies of Small brings five principles for organizations — gleaned from the “Wild West” of venture capital and start-up companies.  Own More, Do Less, Shrink Span, Starve, and Risk it.  These lessons and stories will help you understand why you feel “cognitive dissonance” — that’s a psychology term for feeling “like your head is going to explode” — and what to do about it.

Build a more successful business — large or small — and a more rewarding career by utilizing Economies of Small.

And here is a little tidbit from the introduction:

The first Economy of Small is “Own It”.  Inside a small organization, each individual can see a fit in the overall puzzle.  They can say “this organization / problem / issue is mine.  I own it.  It’s my responsibility.  If I broke it, I fix it.  I own it.”

A football player on defense can see every mistake and success they contributed.  If football teams were 1,000 players a side instead of 11, the individual player would struggle to see individual contribution.

The larger the organization, the more this “principal / agent” problem rears its head.  You have known about the principal/agent problem for some time.  You’ve lived it.  It’s the reason why the hired employees don’t seem to do the job quite as well as the owners.  It’s why Peter Hodgson of Silly Putty generated a personal fortune while Art Frey (inventor of the Post-it note) got just a raise.

Replicating or imitating small organizations allows every person in the organization to feel and act like an owner, seeing how this defensive play saved a touchdown or that offensive play led to a first down.

And just because an employee owns stock options does not mean that she can tell how today’s performance affects tomorrow’s dollars.  Stock option programs were created to address this problem, but options work better for CEOs than employee number 138,213.

Instead, read further and see how to instill “own it” in an organization.

venture capital perspective for social change

I gave a short, fast talking speech to the DGREE conference on how people seeking change should think like Venture Capitalists (in this case, educators, but applicable across multiple goals).

View it HERE

The venture capital business is bad. The stock market is worse

As a venture capitalist, I worry about the future of our industry.  Too much money, high valuations, and no exit markets are just a few of the structural problems to worry about. But, at least we’re better than that bastion of capitalism — the stock market.

The latest data is out on Venture Capital performance through March 31, 2009.  Rather than detail every performance number, think of it this way.  If you had invested $10,000 every year since 1999 in the average venture capital firm, you would have converted your total investment of $100,000 into just $85,000 (after paying the VC partners for their expertise).  Yes, you just lost money.

Well, let’s say you know the best venture capitalists and you know how to “stock pick” your way towards the future winning firms.  Your portfolio of investments would have been all the top quartile firms — the best performers.  In that case, you could have turned your $100,000 into $121,400.  Better, but that’s not even 2% return per year.  That’s worse than inflation.

Your alternative, of course, is the stock market.  If you had put $10,000 each year into the NASDAQ or the Dow Jones Industrial Average, you’d have $69,700 or $72,000 of your $100,000 remaining, respectively.  That’s even worse than the venture capital returns.

(Note that for expert observers I’ve ignored some timing details of IRR calculations and the fact that recent venture funds haven’t had a chance to “ripen”.  These results are still consistent through various assumptions, including looking at the venture returns just up through 2005.)

So what would the stock markets have to be to make you indifferent between the markets and venture capital?  If the NASDAQ reaches 1850 or the DJIA reaches 9,000, a stock market investor would equal an investor in average venture funds.  Those are believable attainments, and the stock markets are way more liquid (you can buy and sell whenever you want or need to.  That’s an advantage).

But to reach top quartile venture returns, the NASDAQ needs to find 2650 and the DJIA needs 12,850.  Those aren’t historically impossible, but they seem a bit far from where we are today (currently NASDAQ is at 1730 and the DJIA is 8418).

While I’m clearly biased in favor of venture capital, the simple fact that I can compare VC to the stock markets doesn’t bode particularly well.  VC is an illiquid investment and it’s riskier, with higher variations than the broad stock market.  For that, venture capitalists have to provide a premium.  Over the 40 years ending in 1998, that premium was about 6% per year higher returns than the stock market.  That means your $100,000 would have to be worth $148,500 dollars today — something not even the top quartile firms have provided.

Stock Options and You

Congratulations, you have stock options.  What are they worth?

Stock options are an important part of compensation in many large and small companies.  And they aren’t just for high-flying CEOs.  Nearly 60% of technology companies have some form of stock option plan, as do many other companies in America, according to Culpepper and Associates, a compensation consulting firm.  Thus, more likely than not, you have or will have stock options as part of your compensation.

But, do you know how much they are worth?  I bet you don’t.

A typical offer of employment for companies both large and small includes at least two important components:  the salary, which is obviously listed in dollars in the US, and the options package, which is typically listed in number of options.  For example, “we would like for you to come work with our great team at ACME.  We’re extending an offer of $75,000 per annum and 25,000 stock options.”

So $75,000 is an easily understood amount, certainly much more so than if it were “75,000 credits”, “75,000 Polish zloty” or “1,234,204 hamster pelts”.  A dollar is a dollar throughout the country.

Stock options can be anything.  And the disturbing thing is, through my work in venture capital and academia, I witness that employers usually don’t try to clarify and employees typically don’t ask.  How much are hamster pelts selling for these days?  What’s a zloty worth?  Tell me more about these options you speak of.

There are some confusing, academic approaches to figuring out what options are worth.  They are useful when companies need to expense their options for reporting purposes.  The Black-Scholes Option Pricing model led to a Nobel Prize, after all.  It’s complex, works far better for public companies than for private companies, and is not widely known by employees.

Instead, employees need to ask, and employers should voluntarily provide, just two primary pieces of information:  option price and percentage of company.

Price me

Option price is typically the price the option holder must pay in exchange for an honest-to-goodness full share of stock.  If the stock of a public company is trading at $30 per share and the option is priced at $10 per share (the “strike price” or “exercise price”, in financial jargon), then as of today, each option is worth $20 ($30 share price – $10 “exercise price”).

Most public market options are awarded with the exercise price higher than the current stock price.  This is so that employees will work towards increasing value, and also has tax advantages for both the company and employee.  The Black-Scholes model does a good job of calculating the odds that these options will someday be worth something.  Another, easier but imperfect way, is just to look at the stock performance of the public company, its variability and trends, and imagine whether there is a chance that these options will someday have value.

Private company stock options are more problematic.  There is no public data to calculate the value of options.  So companies typically price options at a price related to some transaction – either a round of venture capital funding, a price at a merger, or a price calculated by an outside valuation firm.

Then, the company may not tell you this price.  Your 25,000 options could have an exercise price of $0.01 per share or $1,000 per share.  Without the price, you cannot judge whether your options will ever be worth anything.

Colleagues have recounted this story from Board of Directors meetings for private companies.  A company is about to do a new round of funding which would increase the value of its stock by 5 times.  There were new employees about to be hired.  If the employees were hired immediately after the financing, the exercise price of their options would also be 5 times higher.  By waiting to hire the employees, the overall cost of the options to the company declines — while still giving the same number of options (but not exercise price) to the employees.

The oblivious employees, by not asking the price of the options, had the potential of a significant loss in value for the same negotiated compensation.

I do not know the outcome of this temptation in board rooms throughout the country.  I do know that if the future employees were savvy enough to ask questions about the exercise price and stock value of the company, then the temptation to play such games is drastically reduced.

My slice of the pie

For a public company employee, the exercise price can often be enough to understand the value of options.  Extensive data on stock trends and total outstanding shares are readily available thanks to information disclosure rules required by public markets.

But for private companies, market information is not readily available.  Once the exercise price of stock options is known, one additional piece of information is immensely helpful:  your percentage of the company.  This information can come in two ways.  Either “your options represent 0.1% of the company” or “you have 25,000 shares and the total is 25,000,000 shares”, in which case you can divide one by the other.

Your percentage of the company allows you to think about what your shares might be worth.  If you have 25,000 shares and the company has 25 * 10^25 shares, you have such a tiny percentage of the company that even if the company is the next Google, you will not be able to buy a Big Mac with your stock options.

Your percentage ownership allows you to do quick math on any exit that is contemplated.  “Our competitor was just purchased for $200,000,000,” you read, “if we get purchased for that amount, my 1% of the company is worth a cool $2,000,000.  Honey!  Let’s have steak for dinner.”

I have witnessed companies struggle with percentage ownership.  A private company was recently trying to hire employees.  It was offering 10,000 options for hard-to-hire, mid-level engineers.  At 0.5% of the company, the offer was well above the average in Silicon Valley.  The engineers had other offers from a company that was offering 25,000 options.  While always difficult to know, our protagonist company expected the competing offer to be a lesser percentage of the competing company.

Our heroes tried to explain this to its coveted future hires and suggested they ask what percentage the competitive offer implied.  The other company didn’t provide the data, and the temptation of a bigger number (with an unknown value) led the engineers to accept the competitor’s offer.

The solution?  The company split its shares 10 for 1, so that its generous offer increased from 10,000 options to 100,000 options (but the same 0.5% of the company) versus the competition’s 25,000 options.

Details, details

There are a range of additional clarifying questions to ask a private company about your percentage ownership.  “Is the total number of shares you just mentioned inclusive of all shares and options?”  This seems like a ridiculous question, but in many cases companies do not include certain shares in their total (employee stock options are one common example, because they are not yet full shares, just a promise to let you buy shares later).  The number of shares you want for your calculation is called the “fully diluted” number of shares.

Another clarifying question: companies that have raised large amounts of venture capital often must pay that money back before your options are worth anything.  This is called “preference” and the venture capitalists are called “preferred investors”.  If a company is sold for $100,000,000, yippee!  Your stock options are going to make you rich.  Oh, the company raised $150,000,000 in preferred venture capital?  Then your options are worth zero.

There are some questions to ask yourself when considering a private company offer.  Tantamount is “What do I think the odds are that this company will go public or get sold?  At what price?”  Stock options in a private company, like all stock in a private company, have no real value until someone wants to buy them.

Risky Business

In the same way that you wouldn’t accept a check denominated in Klingon currency, so should you not accept stock option offers that are not clearly understood.  Even further, you should hold in suspicion any company or management team that prevents you from knowing the data necessary for you to make an informed employment decision.

For companies, a clear articulation of the circumstances surrounding a stock offer is not just morally justified, but prudent public relations and human relations.  Few things will enrage employees more than the sudden realization that, for any happy outcome below a billion dollar IPO, their stock options won’t pay for extra pepperonis on their pizza.

And they will find out.

Venture Capital Bailout

Amidst the weekly reports of over 500,000 layoffs at U.S. corporations, another contraction is going under-reported.  The number of venture funds is shrinking, with membership in the NVCA dropping from a reported 1,000 firms in 2000 to around 600 today.

But not to fear, the fiscal stimulus package currently in joint committee has something for everyone, including for out-of-work VCs.  The bill increases the dollars headed to SBICs, or Small Business Investment Corporations, by 50%.  SBICs are, essentially, venture capital firms that have Uncle Sam as one of their major investors (known as Limited Partners in VC legalese).

The 50% increase in government allocation to these firms is regardless of their prior performance.  If the VCs lost every dime of their initial investments, they get some nickels to try again.

The rationale for this VC stimulus package is that venture capital firms allocate money to small promising companies prudently, which is true, and quickly, which is not.  Speed is of the essence in saving the economy, but venture capital firms spend several years deploying their initial capital and several more years until the follow-on capital is deployed.  This is not a quick stimulus for our beleaguered economy.

Lack of speed is only part of the plan’s problem.  Venture firms do not allocate their dollars without first extracting a fee.  These fees range from 2 to 2.5% of the money per year, plus 20% of the profits.   With $17 Billion of capital already committed to SBICs, (according to NASBIC, the industry association of SBICs) an additional $8 Billion of new capital in this stimulus plan will generate a windfall of $800 million in fees for the venture firms over the next 5 years.  Those fees don’t save jobs in floundering technology start-ups.  They pay venture capitalists and their staffs.

The fees paid to venture firms to distribute this money represent a tax on deploying this capital, and do not include the costs of the Small Business Administration to administer the funds.  Contrast this with a reasonable alternative – reducing the income or payroll taxes on technology companies to spur growth, innovation, and employment.  The reduction in taxes on these companies is immediately felt by the organization rather than the VC’s one to three year investment delay.  The tax reduction allows dollars to flow completely to the technology company without the bureaucratic tax of the SBA and the intervening VCs.
But perhaps the VC business needs propping up?  No. More capital in the industry will harm venture capital rather than save it.

Even though the number of venture firms has declined over the decade, practitioners and observers still believe that the industry, investing about $20B per year, is over-capitalized.  As recently as 1994, before the dot com bubble, the venture capital industry deployed just over $4B, according to the National Venture Capital Association.  That’s a 13% per year growth rate.  With substantial growth, the competition for investing in start-up companies has increased, raising prices for companies and depressing returns for the entire industry.  The average VC fund has not had a positive return for their investors since 1999.  The venture capital industry needs less, rather than more, money.  More money might continue the malaise for additional years.

While the local economy might benefit from the increased investment dollars and fees spent in our community, the long-term effect on the ecosystem of venture capital and entrepreneurship will be net negative.  The continued poor performance of the venture capital community could permanently break the engine of economic growth that makes Silicon Valley the envy of every Silicon Alley, Silicon Desert, and Silicon India in the world.

The speed with which the stimulus package is being assembled is apparently warranted to head off doom, but the VC bailout is one of many programs we will discover, later, to be under-vetted and susceptible to unintended consequences.

Replicating Silicon Valley in your neighborhood

I’ve had the good fortune over the last few months to meet with the Scottish government, Lt. Governor Diane Dinesh of New Mexico, and U.S. Ambassador to Italy Honorable Ronald P. Spogli. The question they asked was all the same: “how can we bring the venture capital model, so successful in Silicon Valley, to our geography?”

My answer was “don’t”.

The fundamental reason for my advice was that Venture Capital in Silicon Valley has evolved over the last 35 years. It is now nothing at all like it was when it helped start the economic miracle of the bay area. It’s not what’s needed, at least in its current form.

Sure, VC gets an abnormally large amount of press and attention for it’s relatively few 3,000 individuals. But it’s the equivalent of the golf maxim “Drive for show, put for dough”. (I’m at least told this is a golf maxim. VCs spend an abnormally little amount of time driving electric carts through manicured lawns carrying lightning rods.)

VC gets the press for their long drives, and last year invested over $20B in start-up companies. But the small strokes, the putting for dough, is done by angels. Angels in the U.S. also invested over $20B last year. Big business, and not just the “friends, families, and fools” that they are represented to be. They are groups like the Band of Angels, Angels Forum, and Keiretsu Forum.

So my first advice to those asking me how to get venture capitalists to their geographies was “encourage angels”. As a VC, I say “no” to about 300 companies for every one that I invest in. As VCs have gotten larger, they aren’t able to get money to the earliest of opportunities. VCs today don’t invest in the same sized companies as when they were helping build silicon valley. Now, it’s angels that invest in those companies.

My second bit of advice was to focus on “friction”. Specifically, “negative friction” and “positive friction”.

I was amazed at the amount of negative friction present in these geographies. In Scotland, the minimum lease duration is 10 years and the deposits are substantial. To open a corporate bank account, the bank visited the CEO’s home, inspected his personal accounts and those of his wife. In Italy as in much of the EC, it is difficult to fire employees. This is anthema for a startup company with a need to quickly change direction as needed. This friction reduces the velocity of startup companies and the interest among talented would be entrepreneurs.

So to the policymakers with whom I spoke, I suggested reducing this friction. In Italy, for example, encouraging outsourced staffing companies which can lease workers or consultants to start-up companies could reduce hiring friction.

Encouraging positive friction is a bit harder. Positive friction in this context is generated by the rubbing together of people from two different cultures. Cultural change is necessary in these geographies: an increase in risk taking, a tolerance of failure. When I first moved to Silicon Valley, I recall eating at Amici’s Pizzeria. At the table to each side of me were young entrepreneurs starting companies over pepperoni and sausage pizza. It’s the entrepreneurial equivalent of every waiter being an actor in Hollywood.

If students want to learn English literature, they should go to Oxford. If a corporation wants to learn how to manufacture low defect cars, they visit Toyota in Japan. And if you want to replicate Silicon Valley in your geography, generate some positive friction: send entrepreneurs to silicon valley to learn.

It’s working for China. Chinese entrepreneurs are returning to China now. They are bringing skills learned in Silicon Valley and adapting them for the exciting possibilities in their home countries. And this leads to the final bit of advice. “Create poster children”.

In an environment with low negative friction, entrepreneurs have an opportunity to build businesses. One final push would help. Poster children are the examples of what can happen if someone risks, if someone works those long hours. Bill Gates has made the world safer for high school geeks. Baidu.com has convinced millions that billions can be made in China. Scotland, New Mexico, and Italy need similar success stories.

So, it’s “angels”, “friction”, and “poster children”. Obvious, isn’t it?