Interesting to think about how the regulatory scheme, seemingly in the background, really affects the competitive landscape, much like Kickstarter is a nonstarter for startup crowdfunding in the angel/equity model. Crowdselling via kickstarter is what works well.

As an aside, does it make sense to complain about US securities laws? Maybe. Maybe they don’t do the investor protection job very well; that’s presumably a researchable problem. Maybe, of course, you remember that our laws are primarily designed to create disclosure, not safety. Dotcoms going public circa 1999 were all legitimate deals, with correctly disclosed numbers, and pages and pages of risk factors. I know, because I drafted and proofread many of those pages of risk factors myself.

The notion of whether we protect people from bad outcomes misses the point: our system isn’t designed for that. It’s designed to tell prospective investors all the material facts before they invest. Those who say that our assessment of who can and should be able to invest in non-registered securities, such as angel investments in private startups, tend to narrow the issue too much. Those who want to relax the rules often think that these “great deals” are out there and only for the rich. They forget that most of these investments do not create positive returns. And for those who argue that even further reductions(!) in the accredited investor thresholds should be implemented to increase the capital available to startups, they haven’t done the math on the differences in wealth between the original numbers and the current numbers: simply put, people who qualified as accredited investors in the past were wealthier, meaning more able to withstand the volatility and liquidity problems of unregistered investments, than those who qualify at those same wealth or income numbers today. (In other words, inflation happens.)

Angels will largely take a product risk (they bet on the product or idea and your ability to build it). “A” round investors or late-stage seed investors will take a market risk (they want to see the product, vision and maybe even the first customers, and they bet on there being a big enough market). “B” round investors usually take a scale or product market fit risk (they bet that the company can scale and that this is going to be massive).

There are other types of financial investors, and they approach deals differently, which in turn dictates what deals they’ll do. Why is this information important? Knowing how to define and describe the challenge facing your company helps you determine which investors are actually interested in hearing your story and which are not suitable.

• Banks — banks used to make money on the spread in interest rates between deposits and loans, but a much larger percentage of profits comes from fees. Banks, then, seek to aggregate and deploy capital while retaining (traditionally, within the “banking” portion of the bank) little principal risk. Securitization has moved principal risk off of bank balance sheets, helping the transition toward transaction- (and fee-) based models.
• LBO funds — LBO funds are generally focused on financial engineering, meaning they often transmute debt or equity capital into the other kind, and even working capital gets a lot of attention. Changing the capital structure of a business, “right-sizing” ROIC (return on invested capital) across divisions, segments, or products, and even divestments and acquisitions can change a company’s profile. LBO funds take the risk that other capital will be available to suit the models they’ve created and that they can provide the right investment for those other capital markets participants.
• Private equity funds — PE funds clearly span categories in the broad sense, but we think of them in this discussion as the MBO crowd. Backing a management team to buy out a company, likely taking it private, means taking on the risk of product realignment, development, or expansion when those risks are not well-suited for a public company. The fund takes on the risk that the management team has it wrong or won’t be able to execute.
• Hedge funds — Hedge funds have a variety of strategies. Other than the “we’ll do anything” model, a substantial common denominator is arbitrage. But hedge funds don’t just arbitrage price in two different markets but also across time, benchmarks (interest rates), currencies, and imperfect substitutes (commodities vs. commodity companies). That type of risk is more likely to be relevant to a company in its commercial dealings (oil shipments) than in its own financials per se.
• Mutual funds — Mutual funds aggregate vast amounts of capital for investment in public companies and similar securities. These funds effectively take risk by allocating capital to stocks, bonds, and across large sectors (domestic v. foreign, tech v. agriculture). Because of the overall size of the mutual fund industry, it’s probably not meaningful to say that the industry as a whole really takes risks on specific stocks to an extent that used to be true: trillions of dollars have to go somewhere, and mammoth widely held corporations are the place.
• Turnaround funds — These more specialized funds focus on particular types of operating risk, and sometimes related working capital risks. Some focus on pure financial operations turnarounds, others on factory operations, and others on SG&A cleanup. The risk for these funds is based on doing enough diligence before an investment to formulate a plan and staffing a portfolio company with a team that can create and execute the plan as well as adjust it successfully when things change.

Remember, too, that knowing how to describe the problems that you like to attack and solve, as an individual or team, helps you figure out where to target marketing or job search efforts.

Please stop writing about corporate finance. Nobody who worked on this article appears to know anything about securities laws, corporate finance, reasons companies go public, or how to read past issues of this paper.

1. Securities laws: Facebook is subject to the same fundamental law as every other company: Rule 10b5, which says don’t make false or misleading statements to investors. From this perspective, public companies (more precisely referred to as reporting companies to signal the difference) are required to file regular reports for investors. These include the quarterly 10-Q and the annual 10-K. Non-reporting companies have internal contractual requirements that dictate what information they give to investors and when. Here are some common venture capital financing information rights:

Delivery of Financial Statements.

The Company shall deliver to each Investor who holds at least ___________ shares of Series A Preferred Stock:

(a)            as soon as practicable, but in any event within ninety (90) days after the end of each fiscal year of the Company, an income statement for such fiscal year, a balance sheet of the Company and statement of stockholder’s equity as of the end of such year, and a schedule as to the sources and applications of funds for such year, such year‑end financial reports to be in reasonable detail, prepared in accordance with generally accepted accounting principles (“GAAP”), and audited and certified by independent public accountants of nationally recognized standing selected by the Company;

(b)           as soon as practicable, but in any event within thirty (30) days after the end of each of the first three (3) quarters of each fiscal year of the Company, an unaudited profit or loss statement, schedule as to the sources and application of funds for such fiscal quarter, an unaudited balance sheet and a statement of stockholder’s equity as of the end of such fiscal quarter and a statement showing the number of shares of each class and series of capital stock and securities convertible into or exercisable for shares of capital stock outstanding at the end of the period, the number of common shares issuable upon conversion or exercise of any outstanding securities convertible or exercisable for common shares and the exchange ratio or exercise price applicable thereto, all in sufficient detail as to permit the Investor to calculate its percentage equity ownership in the Company.

(c)            within thirty (30) days of the end of each month, an unaudited income statement and schedule as to the sources and application of funds and balance sheet for and as of the end of such month, in reasonable detail;

(d)           as soon as practicable, but in any event thirty (30) days prior to the end of each fiscal year, a budget and business plan for the next fiscal year, prepared on a monthly basis, including balance sheets and sources and applications of funds statements for such months and, as soon as prepared, any other budgets or revised budgets prepared by the Company; and

(e)            with respect to the financial statements called for in Sections 4.1(b) and (c), an instrument executed by the Chief Financial Officer or President of the Company and certifying that such financial statements were prepared in accordance with GAAP consistently applied with prior practice for earlier periods (with the exception of footnotes that may be required by GAAP) and fairly present the financial condition of the Company and its results of operation for the period specified, subject to year‑end audit adjustment.

Additional Information and Rights.

The Company will permit any Holder, so long as such Holder (or its representative) owns at least _________ Registrable Securities, or such number of shares of Common Stock issued upon conversion of _______ or more Registrable Securities, or any combination thereof (as presently constituted and subject to subsequent adjustment for stock splits, stock dividends, reverse stock splits, recapitalizations and the like) (a “Significant Holder”) (or a representative of any Significant Holder) to visit and inspect any of the properties of the Company, including its books of account and other records (and make copies thereof and take extracts therefrom), and to discuss its affairs, finances and accounts with the Company’s officers and its independent public accountants, all at such reasonable times and as often as any such person may reasonably request.

The same law governs these statements as the 10-Q in terms of not making material misstatements. Yet here’s the RSS tagline for the article:

Flush with cash, Facebook may be able to delay an initial public offering of stock and remain free of government regulation.

The only thing that Facebook will remain free of is reporting obligations that make their data available to the general public and competitors.

2. Corporate finance — the current investors in Facebook are subject to qualification under the securities laws. Individuals are generally required to be accredited investors, meaning they meet certain income or net worth tests. The creation of investment funds, like the Goldman Sachs investment you describe, are designed to comply with the laws, not “skirt” them. The SEC addressed these permutations long ago and created regulations to divide permissible private offerings with a given set of requirements from de facto public offerings with a different set of requirements. Even the vaunted 500 shareholder number is designed to separate companies into these two types.

The investment world does not thrive on heads I win, tails you lose bets (except, perhaps for brokerage commissions!). The answer to whether opening investment in venture-stage companies to the general seems to turn on whether they’re going to be successful, as if that answer is known in advance. Plenty of companies, big and small, public and private, fail miserably. Some succeed. It’s just silly, and frankly disingenuous, to suggest that the general public, not deemed by the paternalistic securities laws to be capable of protecting themselves, are being kept away from some sort of free money deal; at least it’s silly to do so without acknowledging the reason those laws prevent them from taking part in such investments is to keep them from losing money when they don’t understand what’s going on.

Please correct this mismatched theory/application mashup and remove any hint that ordinary investors are getting scammed by not being able to invest in Facebook. Instead, remind them how much money they lost on Webvan and pets.com. That sort of article might educate readers, especially those without knowledge of the securities and venture capital industries, what the real issues are. The article you wrote belongs in USA Today. I’m sure you could at least dig up some of those post-dotcom bust articles and link to them (that might even help monetize the archives) to round things out if new words cost too much.

/s/ ThoughtStorm Strategic Capital

Although the mind instinctively rejects all needless complexity, we shall greatly err if we fail to recognize the fact that what the mind recoils from is not the complexity, but the needlessness.

G.H. Lewes, “Simplicity,” in Foundations of English Style 108, 108 (Paul M. Fulcher ed., 1927).

Our vision for financial management for companies employs tools that state simply the relationship between operations and free cash flow. These tools are designed to enable increased complexity as the nature of the investigation, analysis, and effect changes.

We have learned that introducing complexity at the right time makes a big difference, especially when you can teach an analyst or manager how to *really* understand how the business works.

The key point here is not whether any particular structure is “right” for every transaction. The point actually is that your CFO, or your lawyer if he knows how to work a spreadsheet, should keep track of your capitalization table and what it means. The “what it means” part is, in my experience, best done graphically, depicting the payouts to various groups of holders at different liquidation prices. (In every set of venture documents I’ve seen, a merger or acquisition is treated as a liquidation.) That depiction has to take into account conversions, exercises, and the conditions and triggers that cause them.

My best story about this issue comes not from an M&A transaction per se, but from a set of unusual liquidation preferences I read in a term sheet. The terms included different multipliers at various thresholds, and something about the text didn’t make sense to me. I checked with the venture associate (who had actually been a corporate lawyer at my old firm) to confirm. The answer back was “yep, that’s what we want.” I have a habit of being too smart for my own good sometimes, and so I didn’t take the client’s answer for a given (frankly, that’s not my job — my job is to get it as right as possible). Instead, I did the only thing that made sense to me — show that the terms were somehow wrong. (NB: the meta-lesson here is that reading terms like these, particularly when they are complex, and certainly when you are reading several sets of terms in conjunction with one another, is really damn hard.) I chose to do that with Excel.

I put together a relatively simple graph, showing the total value of the company vs. the share for common and series A (or B or whatever it was) holders. The answer became obvious: the language as written operated to give the new investors, less money as the company became more valuable from $200m to $300m (or something like that). That never makes any sense. Keeping their share static, or shifting the share different ways, all could make sense and provide distinct incentives to management: but taking money out of anyone’s pocket in that scenario makes no sense.

I’ve left it unedited and uncleaned (the axes are atrocious, the legend is back in excel, etc.) because all you have to do is look at those two vertical lines at $211m and $240m company valuation and see the problem.

This type of analysis doesn’t have to happen on a daily basis; it’s not a dashboard item. But in the middle of, meaning before signing, any capital raise or other issuance of equity, you’d better have one of these from your CFO. Or your banker. Or your venture consultant. Or your lawyer (and if your lawyer doesn’t know how to do this in excel, call one who does). When skilled venture-firm folks can make these mistakes, it’s certain that company management does too.

Put this cautionary tale about underperforming yet accurate inside information in the “memo to file: illegal things that don’t make you money” category.

If personal income tax rates are going to increase, then, as the article states, it make sense to defer donations until the years when the value of the tax deduction is increased. (To the donor, that return is all free money, so it’s not really appropriate to compare it to an alternative. To the donor.)

Of course, the value to the organization of having funds a year earlier than otherwise is much harder to measure. It’s determined by the weighted-average cost of capital of the organization, the amount of existing resources (e.g., does the organization have an endowment, or does it operate on an annual cash basis only?), and the value of the return on social capital (as we’ve termed it — basically, what’s the bang for the buck achieved by the organization?).

Many people will continue to give in the same amounts as in prior years and not modulate their use of funds to track tax rates (of course, economists might disagree).

One tactic we’ve identified to assist those who both recognize the need for consistent, if not increased, levels of donations and prefer to take advantage of tax incentives at the margin is to make a multi-year pledge to an organization.

The pledge is generally not a deductible event, since the funds have not been actually donated (and the accrual is meaningless for cash-based accounting entities, such as individuals). Nevertheless, a significant amount of pledges can be relied on by many organizations to modulate their own productive and efficient use of resources. For example, a college knowing that a $500,000 pledge will be paid next year might be willing to expend those funds from its endowment this year in anticipation of the future gift.

Will this work everywhere? No, and particularly not when organizations have little resources to re-allocate; causing your favored recipient to go into the market for debt capital to replace your pledged-but-undelivered funds is not likely to be an efficient use of resources or to result in any real return from the delay to take advantage of the increased tax benefit.

Mass – Concentrate combat power at the decisive place and time

What mass means from the military perspective is that you bring together whatever forces are necessary to achieve a desired result. An example would be moving forces from different locations to all take part in one operation, such as the seaborne invasion of Normandy in three locations with hundreds of ships coupled with airborne troops jumping behind enemy lines. The combination of the two achieved results far superior to either one, and if these pieces hadn’t come together at the same time (bad weather during the channel crossing) or at the right place (mistakes in the drop zone coordinates away from targets), the overall effect is diminished and could even lead to a non-victory: not necessarily a defeat but certainly a failure to accomplish the mission. When pieces fall away entirely, defeat is certainly possible, such as in the Bay of Pigs when air support was not available as planned.

Mass is, however, more about the concentration than the place and time elements. Concentration of resources requires us to choose the battlefield (literally and figuratively). The example that sticks out most for us in thinking about business applications of the principle of Mass is Jack Welch defining target markets for his businesses. Welch said that GE should select only those markets where they could be #1 or #2 in the market. (To prevent tweaking the definition of a “market” to ensure success, a condition was added that GE couldn’t have more than 10% of the defined market.)

GE marshaling its resources to achieve the required market position is an example of the principle of mass.

Another example that should be familiar to most readers is the seasonal or periodic business. In many industries, a disproportionate percentage of the business takes place during a season or around a specific time/space location. Vacation rentals match up with snow/beach season, depending on location, CPAs are most busy immediately prior to April 15, and trade shows in some markets dominate certain segments of commercial activity. A good example of the latter is fashion, where although people buy clothes all the time, manufacturers take most of their orders around trade show events, which are then delivered months later for the appropriate seasonal merchandising. Manufacturers who are not able to Mass their resources to produce marketing materials, samples, and presentations for buyers prior to the trade show risk calamity.

How do these thoughts impact our new definition of the principle of Mass? Originally, I thought that the GE market dominance example was going to be the heart of the new definition. But the principle isn’t one that’s static; it’s dynamic, like maneuver or flexibility. Mass is about doing things, making changes, and selecting goals (more on this later when we discuss Objective).

Version 1: Mass – organize your business to be able to take full advantage of decisive moments

For many businesses, their strategy will dictate what moments are in fact decisive. For consumer retail businesses, it might be the selection and stocking of products, i.e., getting all the boxes into Wal-Mart. For consumer product companies, it might be the end-user customer’s decision to choose one bottle over another sitting next to it on a supermarket shelf. Different companies will have different decisive moments, some of which will seem to be far from the moment of revenue recognition: think value creation instead.

Mass – organize your business to support the moment of value creation

Ed. Note: This post was originally written in May, 2008. It apparently disappeared from the site but is back now. Look for more posts like this, and a forthcoming book on the topic.

The truth is the complete opposite. From a traditional corporate finance perspective looking down to small businesses, the questions are exactly the same: you need to focus on (and ONLY on – we can’t say it enough times) free cash flow. Cash flow for small businesses is easier for many business owners to understand if we talk about it in terms of actual cash, like money in the register, and start describing the business on that basis. Then we add in layers of detail (paying over time, getting paid over time, buying assets such as inventory with cash, or buying capital assets with cash) to help bring the owners along to what we see all the time. Those concepts aren’t inherently difficult, IF they are built up one by one and not wrapped in consultant jargon such as “driving revenue” or “high performance.”

We also, of course, advise and analyze small businesses. The message that we aim at clients who have understandable deficits in knowledge and experience with Fortune-500 corporate finance is that the rules, the equations, for money and finance in a big company are exactly the same as they are for a small business and are exactly the same as they are for people. Many of these business owners are successful because they have a good handle on their own money.

Harris Interactive made a big deal some years ago with their “myCFO” website or “solution” or “offering.” They tried to latch on to the same idea, but my recollection is that they didn’t actually provide anything remotely like an actual CFO service or advice for clients in the comprehensive way that we’ve done for ultra-high-net-worth clients. Instead, they provided the unremarkable service of selling investments. The original plan may have been different, but they ended up someplace else.

What’s the core lesson? It’s all finance; there’s only one finance; finance applies to *you,* to *your family office,* to *your small business,* to *your company.* The equations are the same even if many things are simpler in a small business; the equations are the same even if you are an UHNW family and your holdings seem irretrievably complicated. ThoughtStorm has applied our cutting-edge financial analysis and management tools to the needs of each of these clients. Contact us to learn how you can put real finance to work for you.