Venture Capital and Private Equity: The Same, Only (Very) Different

February 3, 2012

By: Paul Jones

If you’ve followed Presidential politics of late – and as much as I want to look away I find myself gawking at a freeway pileup – you have no doubt heard a lot about private equity and venture/vulture capital. The good news is that much of what you have heard is not true; which, I suppose, is also the bad news. Herewith a brief attempt to provide a little clarity.

First, in a very technical sense, venture capital (VC) is a kind of private equity (PE). Both terms refer to pools of capital assembled by professional management/investment teams from wealthy individual and institutional investors in private offerings. However, in a practical sense, the VC business is fundamentally different from the PE business. As for “vulture capital,” the term is more of a slogan than a description of a business, but to the extent it somehow describes a business strategy it more often than not makes its appearance in the PE world.

Now, VC and PE investors are both out to make money; in fact, they are both out to generate returns that exceed the returns typically available in public securities markets. They both look to generate those returns by investing in businesses with higher risk/reward profiles than those that make up the vast bulk of securities on the major public stock exchanges. But as to how they expect to generate those returns, VC and PE are typically worlds apart.

Fundamentally, VCs make money by building new businesses. PE investors, on the other hand, generally make money by restructuring existing business. VCs are “clean slate” investors in the sense that they typically invest in young businesses with little or no track record with the expectation that those business will become “the next big thing.” Think Google, as an example of a VC deal that worked, and, say PetCo as a VC deal that failed. PE investors, on the other hand, generally invest in established businesses that have fallen on hard times, or are otherwise perceived as not performing to their potential. Think Hertz as a PE deal that worked and, say, Sears as a PE deal that (so far) has not worked very well.

Some more differences. VCs typically do not assume operating control of the businesses they invest in. They are active investors, to be sure, but fundamentally investors, not managers. PE investors, on the other hand, typically see themselves not as supporting but rather as taking over management of the businesses they invest in. VCs typically invest in businesses with no debt, or in later stage investments with limited debt. PE investors, on the other hand, usually leverage their equity investments by having the business take on debt that substantially exceeds the amount of equity the PE firm invested. Thus, most PE investments are in the form of “leveraged buyouts” or “management buyouts.” Finally, if and when a VC-backed company achieves an exit for its VC investors, the company will almost certainly employ more people, usually a lot more people, than when the first VC money was invested. In contrast, if and when a PE-backed company achieves an exit for its PE investors, the business will more often employ fewer people than it did when the PE investors first entered the picture.

While I have spent most of my career in and around the venture capital world, I am not going to argue that VC investing and investors are somehow better or worse than PE investing and investors. They both have their place, which, I think, can be summarized as follows: VC is about creating new value in new vessels, while PE is about salvaging value otherwise locked up in old, deteriorating vessels. The strongest economies excel at both.

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Thinking About Dilution

January 19, 2012

By: Paul A. Jones

For most entrepreneurs, dilution is an ugly word. Being diluted, after all, is about giving someone else a piece of your business. All other things being equal, that’s not a good thing. That said, for entrepreneurs that need third party risk capital to fund their business, dilution is inevitable. And (the silver lining in the dilution cloud) not always as bad as it might seem.

Entrepreneurs facing dilutive events typically have two concerns, both related to a reduction in relative ownership of the business: loss of management control and a diminished share of the “upside” if the business succeeds. Let’s look at control issues first.

Fear of losing management control to investors is something that keeps a lot of entrepreneurs up at night. Too often, though, the fear assumes that there is some magic number – usually 50% ownership – around which control pivots. Alas, it is not anything like that simple. The (possibly disturbing) fact is, an owner of the smallest fraction of a company’s equity (indeed, a creditor without any equity stake at all, though that is a matter for another blog) can have de facto control of a company’s management. And, indeed, venture capital investors with minority ownership positions almost always have substantial management control, as for example rights to prohibit strategic transactions (e.g. sale or merger of the business), limit future sales of equity, etc. well beyond those rights they would enjoy from a simple “who has the most shares” analysis. The devil, in terms of management control, is in the fine print of the deal terms, not the gross percentage of equity owned. The take home here is that control in venture backed startups is more a function of the (hopefully thoughtfully negotiated) finer points of the deal terms than simply a function of who has the bigger/majority equity interest.

As for dilution reducing an entrepreneur’s share of the upside, by definition, an equity investment involves some grant of interest in future profits and/or exit value to the investor. (For purposes of this blog, we’ll assume that the investor’s stake is commensurate with its ownership stake, though it need not be: while an investor’s ownership stake is less likely to diverge significantly from the investor’s ownership share than its control rights, such discrepancies are not uncommon, if not usually as significant.)

Now it is fair enough to say that giving a third party any stake in the ultimate equity value created by the business necessarily dilutes the interests of the prior stakeholders. But the story is more complex than that. Taking on a new investor is a priori (if not always a posteriori) a classic win-win proposition. More specifically, the investor is investing because he believes that the investment will grow in value, while the entrepreneur is accepting the investment ( and dilution) because she believes that the value of her diluted share of the post-investment equity in the business will exceed the value of her (undiluted) pre-investment equity. Unless both parties anticipate a wealth enhancing proposition, there won’t be a deal.

The win-win story is most easily understood in the context of an “up” round: that is, where the new investor pays a higher price than the prior investors. So, for example, an entrepreneur who owns say 50% of a business where the previous investor paid $1.00 per share is demonstrably wealthier if she takes on an additional investor at $2.00 per share even if doing so dilutes her ownership down to 25%. In fact, her wealth (even if not her liquidity) has been doubled (she now owns the same number of shares, each of which is worth twice what it was before the investment).

The $1.00/$2.00 example above does not mean that an entrepreneur should always accept dilution if doing so would increase her wealth. It may be that while the $2.00 offer doubles her wealth, the ownership stake she is selling is worth more than $2.00 to some other investor. What the example does illustrate, though, is that a dilutive event can also be a wealth enhancing event. Indeed, even in a down round scenario (say the price goes from $1.00 to $0.50 per share) the entrepreneur should only accept the dilutive event if she feels that her diluted ownership stake after the investment will be worth at least as much as her undiluted stake if she forgoes the investment.

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Corporate Venture Capital: An Entrepreneur’s Perspective

January 16, 2012

By: Paul A. Jones

While never a dominant part of the venture capital industry, corporate-sponsored venture capital investors (think for example AOL Ventures) have long been an important part of the industry.  Entrepreneurs thinking about seeking venture capital should, preferably at the beginning of the quest, consider whether they want to seek, or will even consider, corporate venture capital.  For some deals, corporate venture capital is a priority; for most it is an option; and for some, it might be a last resort.  Herewith, some of the issues to consider.

Corporate Venture Capital as Deal Validation.  Generally, the more technology risk a deal has, the more attractive corporate venture money is, all the more so when the expected amount of pre-revenue capital needed and time to market are greater. Corporate venture capital is often a plus, for example, in biopharma deals, where technology risk, capital needs and time to market are huge.  Getting a corporate fund in a deal sends a powerful due diligence signal to all but the highest tier traditional funds (they are as a rule less impressed by third party due diligence) that the science passes the blush test.  On the other hand, deals where time to market, technology risk and risk capital requirements are not so great – say, a niche social networking concept – are not likely to get as great a validation enhancer across as broad a range of traditional funds.

Corporate Venture Capital as Lead Investor – Usually Not.  As a rule, corporate funds don’t make very good lead investors.  First, while a corporate fund can be a nice validator, getting too close to a corporate fund can make doing business deals with companies that compete with the corporate fund’s parent harder to do.  If “Competitor A” is your lead investor, “Competitor B” will be understandably more cautious about doing a deal – or even sharing information – with you than if Competitor A is only a follower in the deal.  Further, remember that most corporate funds (there are exceptions: ask) are not “pure return” investor, and thus is not in a good position to set the price – which is one of the important things the lead typically, well, takes the lead on.  (Traditional funds will – quite correctly – discount an entrepreneur’s assertion that a price agreed to by a corporate fund is a fair price, particularly if the corporate fund is not a pure return investor.)

 Corporate Venture Capital: The People Difference.  Not to say that there are not exceptions, and not to say that corporate venture capital professionals are not exceptional in their own corporate worlds, corporate venture capitalists are as a general rule not the brightest bulbs in the venture capitalist universe.  First, compensation at most corporate venture capital firms is generally not as generous/aggressive as at traditional funds that don’t have to “fit in” to a broader corporate compensation system.  If traditional venture capital firms pay more, you would expect they would attract the best people.  Second, corporate venture capitalists, while needing, of course, to earn the confidence of senior corporate managers, don’t have to go through the hurdle of successfully selling themselves to a typically fairly large group of sophisticated investors who specialize in evaluating venture capital professionals as traditional venture capitalists do.  Finally, most traditional venture capitalists – certainly the stereotypical venture capital professional – are folks with big egos who like to make others fit to their rules rather than vice versa.  That’s a personality profile that doesn’t generally fit very well in  below C-level jobs in big business management cultures.  

Corporate Venture Capital:  Here Today, ….  Whether considering a relationship with a traditional or corporate venture firm, one criteria, of course, is how long a fund team  has been around: generally, fund teams that have managed several funds across several investing cycles are more desirable investors than less experienced funds. While there are notable exceptions, corporate venture capital funds don’t as a rule have the staying power of more traditional funds, as in addition to the performance hurdles all funds must overcome to stay in the business over the long haul, corporate funds have some of their own longevity issues.  For example, being pieces (usually small ones at that) of much larger enterprises, corporate funds are subject to the whims of senior management teams that at most companies blow hot and cold on venture capital investing, depending on short-term earnings pressures and more broadly shifting management priorities over the corporate cycle and as senior managers come and go.  Entrepreneurs considering venture capital should, to the extent possible, try to focus on corporate funds that have demonstrated both some staying power and some real success (which, of course, are also good criteria for evaluating competing proposals from traditional venture funds, too).

As noted, corporate venture capital is an important if relatively small part of the broader venture capital industry.  There are, as with traditional venture capital funds, good corporate venture investors and not-so-good corporate investors.  The ideas noted above are offered not as hard and fast rules – for all of them there are exceptions – but rather as a framework for analysis.  An analysis that entrepreneurs are wise to undertake before launching a campaign for venture capital funding.

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It Takes More Than Grey Hair

December 13, 2011

By: Paul Jones

One of the more pernicious mistakes many less experienced entrepreneurs make is assuming that successful “big business” executives are as a rule well suited to managing smaller high impact businesses.  It’s a pernicious mistake because few things can derail an otherwise promising startup faster than putting the reins in the hands of a poorly suited, even if highly decorated, big company manager.  It is a mistake I once made at one of my own startups, and one that I have seen others make too many times.

There are several reasons big company executives – not all of them, but a lot of them – fail when they transition to the startup world.  Most are related to the notion that managing a startup typically involves making “bet the company” decisions more often (as often as daily, and seldom less often than monthly), with less information, in less time, and with less input from appropriately experienced colleagues, than managers of larger, more established businesses.  Another startup attribute that can flummox big company executives is a culture that places much more emphasis (and reward) on rapid identification of mistakes, and much less on assigning blame for them.  Finally, most big company executives come from a world where the risk reduction paradigm is based on diversification, while for most startups risk reduction is based on focusing limited resources on a very narrow front (albeit one that can change overnight: see above re “bet the company” decisions).

None of this is to say that good big business managers are as a rule not well suited to be good managers of startups.  The point, rather, is that the demands of the jobs – and thus the skill set for doing them well – are different in the two worlds.  Some folks can transition from one world to the other, some folks can’t. 

Of course, figuring out whether a particular big company manager can succeed in the startup world is the real trick.  On that score, I have yet to find a sure fire test.  In my experience, one good approach is, once a candidate has passed the blush test and knows a little bit about the opportunity at hand, to ask her “so, tell me, if you were to start tomorrow what would you do first?”  Look for an answer that focuses on action, not analysis.  Look for a “take charge” attitude: avoid, at all costs, a candidate that looks like a deer caught in the headlights.  Another good approach is to emphasize how, well, broke the company is, or will be soon, without new capital or new/accelerating revenue – and how little the company spends on support staff and services.

If my suggestions seem inadequate, well, they come from experience as an entrepreneur hiring my replacement as CEO.  He had all the right industry experience and networks, and the grey hair to go with it.  If only we had asked him what he would do on his first day at the office, we might have learned about his need for an Executive Assistant, and his passion for good HR policies – as, for example, a standard, monthly process for recognizing the birthdays of the various members of the team.  If we had, we might have avoided making a fatal mistake.

 

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IRC 409A: Good Faith is Good, but not Good Enough

November 1, 2011

By: Paul Jones

From very early on, one of the distinguishing features of the Silicon Valley school of innovation was the notion that virtually every one on the team – from the receptionist at the front door to the founders in the corner office – should have a stake in the success of the venture.  While founders and in some cases other very early employees often acquired their “sweat equity” in the form of common stock, most later employees got their “upside participation” in the form of options to purchase common stock – typically at a price substantially less than the price paid for shares of preferred stock by more or less contemporaneous venture capital or other sophisticated investors.  How much less?  Well, therein lies a tale; alas, an increasingly frightening tale in recent years.

By way of background, in the good old days of sweat equity pricing – say, before 2004 (more on that later) – the task was in principal more or less what it is today.  The option exercise price was supposed to be set at the fair market value of the common stock on the date the option was granted.  The “technical” problem of figuring out fair market value was as much ritual as science: the process typically culminated in a boilerplate board resolution that implied a timely, exhaustive, good faith effort by the board – that in reality was mostly driven by rules of thumb.  Among those rules, the “common is worth 1/10th the preferred at the time of a first round venture financing” was one of the most popular.  Life was more or less good for founders, employees and investors alike.  As for the IRS, well, if you stuck to the rules of thumb and backed it up with the appropriate boilerplate, the IRS generally looked the other way.

And then came 2004, and Internal Revenue Code Section 409A, and the game was up.  Valuation rules of thumb were out (bad enough) and the cost of getting it wrong went way up (much worse).  Whereas in the good old days a board could be pretty confident that using a rule of thumb to set the valuation (albeit dressing it up in the board resolutions) would keep the IRS agents away, these days a board often does considerably more than that if it wants to sleep well at night, IRS-wise.  First, because 409A essentially eliminated using rules of thumb to determine fair market value in favor of some very particular – in terms of factors to be considered in setting a valuation and who should do the considering and how often – guidelines.  Second, because the cost of getting it wrong (in the old days mostly theoretical if occasionally somewhat problematic from an accounting perspective in an exit transaction) went up.  Way up.  For the employee, the company, and potentially even the individual members of the company’s board of directors.

Okay, first to the valuation question.  409A provides (in broad substance: this blog is a business heads up, not a comprehensive or even summary legal analysis) a specific list of factors that must be considered in making a valuation determination.  It also provides specific criteria as to who can do the valuation analysis if you want the IRS to take it seriously.  Alas, for most venture-backed companies the folks that qualify under the criteria are generally independent,  appropriately experienced, and expensive (say $5k to $50k depending on stage of development of the business and complexity of the capital structure) professional appraisers.  Follow the rules (i.e. absorb the expense) and you can be reasonably (if not totally) certain that the IRS will find better ponds to fish in than yours.  Don’t follow the rules, and ….

What can happen if you mess up a 409A valuation?  It’s not pretty.  Let’s take a hypothetical, and to make it both simple and less scary, let’s start with what happens if an employee is granted a vested option to purchase a single share of common stock at an exercise price of $1.00, and that the IRS later (say 12 months later) decides the fair market value was $3.00.  Well, first the employee is on the hook for not paying federal and state taxes on the $2.00 difference between the option exercise price of $1.00 and the IRS determined fair market value of $3.00.  Oh, and on top of that a 20% penalty tax and likely interest.  (And in some states, like California, an additional 20% penalty.)  And the company – and if the company can’t come up with the money, the various directors of the company personally – are on the hook for the unwithheld withholding taxes on the $2.00 – over and above the cost of redoing the accounting books to reflect the added compensation expense.  Ugly, indeed.

And, of course, it gets worse.  Because in most cases stock options vest over time; that is, an award of say 1,000 option shares might vest over four years.  At each vesting date, figure out the difference between the exercise price and the then fair market value and repeat the calculation for the shares that vested.  Even uglier.

So it looks like directors of venture backed companies that want to sleep well at night need to comply with 409A, such compliance most likely to include spending scarce corporate cash resources on periodic (at least every 12 months, and in many cases more often than that) professional appraisals of their common stock.  Among the prices we pay, I guess, for living in a post-Sarbanes-Oxley world.

An important footnote.  Some entrepreneurs and investors take the view that the fair market value exercise price problem posed by 409A can be avoided by simply setting the option exercise price at least equal to the then preferred price.  That’s true, if perhaps too clever.  If you live someplace where likely employees don’t understand the value of having an option exercise price below the current investor preferred price, well, good for you (not really, but that is another story).  Except that if you ever find yourself needing to bring on board a key player who does understand the difference you are going to have a problem figuring out how to explain to everyone else why their options are priced higher than the new guy’s.

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Convertible Debt Financing: Thoughts on the Default Conversion Price

October 25, 2011

By Paul Jones

Convertible debt financing structures, with or without equity kickers, are a popular choice for many seed stage entrepreneurs and investors.  (Disclaimer: this blog is about first money in seed investments, and not about the many other situations where convertible debt structures can be profitably employed.)  The ability to punt on the contentious and often problematic valuation issue until some combination of greater opportunity visibility and/or attracting larger post-seed investors to the table can be very attractive to the entrepreneur and seed investor alike.  However, while the concept is based on the notion that a valuation will ultimately be established in the context of a future, larger round of equity financing, what happens if no such round ever takes place?  Presumably, the seed investor will want to have the option to convert at some valuation (to participate in the upside) – without being obligated to convert to equity at any valuation (to protect on the downside).  It thus seems that while convertible debt financing makes the valuation issue at the seed stage less contentious than it might otherwise be, it doesn’t completely remove valuation from the negotiating table.  The entrepreneur and seed investor will still have to agree on a default conversion valuation if the anticipated post-seed “conversion trigger” financing doesn’t, for whatever reason, happen.

Before talking about the default conversion valuation, let’s consider when it comes into play.  A typical seed convertible debt financing anticipates that there will be a larger downstream “conversion trigger” financing, with the valuation in that financing serving as well as the valuation for conversion of the seed debt.  Usually, entrepreneur and seed investor alike put a lot of thought into how big the future finding has to be to trigger conversion of the debt.  While each party may have its own ideas on what the trigger valuation needs to be, those ideas are more often than not relatively easy to bridge.  Both sides will want a trigger financing to be big enough (particularly if there is an equity kicker associated with the convertible debt) to assure that the “convertible tale does not wag the trigger investment dog” so to speak.  And both parties will presumably have some more or less similar ideas on at least the minimum amount of next round capital the business will need to get to the round after that (or exit, if you are an incurable optimist). 

But there is a more subtle piece of the trigger financing question.  How long does the company have to pull it off?  Put differently, besides defining the amount of capital that must be raised to trigger conversion of the seed convertible debt, you also have to set an outside time limit on that financing: a time after which, if no trigger financings has occurred, the seed convertible debt will have the option to convert at the default conversion valuation.  On that score, sooner is better for the seed investor and later is better for the entrepreneur – but at the end of the day, the entrepreneur should not rush into a short fuse no matter how certain she is that the trigger financing will happen sooner rather than later.  In my experience, most seed investors will accept a 12-18 month time frame for the trigger financing, and, well, the longer the better.

Finally, we get to the heart of this blog.  Given that higher is always better for the entrepreneur, and lower is always better for the seed investor, how should the parties approach setting the default conversion valuation?

Let me cut to the chase and then circle back on the rationale.  In my experience, a good default conversion valuation is one that will, if the seed investor decides to convert at that time/price, result in a fully-diluted ownership stake in the 10-20% range.  If that sounds arbitrary, well, it is.  But capricious it is not.  Here’s why.

Lets start by predicting the future of the entrepreneur’s business, focusing on just those futures that are most likely if you assume that no conversion trigger financing ever takes place.  It seems to me that the vast majority of such futures will fall into one of two buckets.  Either the business the business tanked without ever getting additional financing, or the business took off without needing additional financing, or.  In the later case, the seed investor will not want to convert, it being all but certain that remaining in their creditor position will maximize the amount, if any, of their investment that is recoverable.  And this should be fine with the entrepreneur (who, of course, was wise enough not to sign any personal guarantees (which, if you think about it, makes sense – but that is a digression).

So what about the case where the business became wildly successful, without ever needing to raise additional equity capital?  Shouldn’t, in that case, the entrepreneur fairly expect a very high valuation for the conversion of the seed debt?

In theory, yes, but lets look at the practicalities of the assumed outcome.  The entrepreneur will, in my 10-20% dilution scenario, find themselves with 80-90% ownership of a business that, short of an exit transaction (or perhaps bank or other non-dilutive financing), by definition does not need additional equity capital.  Sure, at a higher default conversion valuation, they would own an even bigger piece of the pie.  But at some point, shouldn’t the entrepreneur ask herself something like the following question: “Just how rich does the seed investor have to make me before I will be satisfied – given that the seed investor’s money is what got me all the way home, and that my expectation going into the seed round was that there would ultimately be a lot more than 10-20% dilution before we got home?”

Now, every situation is different, and there are situations where my 10-20% default conversion rule of thumb may not be the “right” answer (whatever that is).  But it does seem to me that an entrepreneur who hits a home run so much faster, and with so much less risk capital than even she thought possible, well, she ought to be able to share a little of her good fortune with the seed investor who made it possible.

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Steve Jobs: Concept Precedes Design

October 11, 2011

By: Paul Jones

Among the many tributes to Steve Jobs on his passing, perhaps the most common theme is the man’s prowess as a designer.  And, indeed, from the Mac to the iPod to the iPhone to the iPad (if not so much Newton, or Lisa, or iTV, or …) Jobs’ talent for matching form to function was nothing short of astounding.  Asking his successors at Apple to maintain the standards he set is asking a lot.  But for arguments’ sake, let’s assume they can do it.

Unfortunately for Apple, meeting the design challenge will only get them part way home in terms of living up to their now departed leader’s legacy.  Because as good as Jobs may have been as a designer, he was even better as a conceptualizer: which is to say, his conceptual prowess was at least the equal of his design flair, and while I can – well, sort of– imagine that Jobs’ successors at Apple can design a better iPod, iPhone and iPad, I really struggle with the idea that they will be able to conceive of the next, well, iNext.  And, ultimately (which is to say probably within a year or two or maybe three at the outside) Apple will have to come up with a compelling iNext to keep the Apple juggernaut on top of the tech world for the next few years after that.

Design, ultimately, is a craft, and Jobs was a superb craftsman.  The ability to conceive something utterly new in function as well as form, on the other hand, is the mark of true genius.  Making a better iPad is a big task, but not as remotely challenging as conceiving the notion of the iPad in the first place.  Even conceding that Apple has the talent to live up to Jobs’ standards in the design of the next iPhone, it strains credulity, I think, to believe that anyone at Apple can match Jobs standards and timing in conjuring the iNext.

Look at it this way.  Suppose you had to rank three teams in terms of how likely each was to conceptualize a blockbuster iNext.  Team one was the Apple team with Jobs.  Team two was Jobs, and team 3 was the Apple team without Jobs.  Go ahead, rank them.  Doesn’t your ranking (we all came up with the same ranking, right?) tell you something about Apple’s likely longevity as the center of the consumer technology universe – or at least as the most valuable company on the planet?

 

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Serious Patent News: Some Good, Some Not So

September 7, 2011

By: Paul Jones

Any day now, the Senate will likely pass the America Invents Act, with the President’s signature promised shortly thereafter.  The Act will make the most sweeping changes to United States patent law since at least 1952.  By moving the United States from a “first to invent” patent paradigm to a “first to file” paradigm it will align the country with the vast majority of other nations, and will most likely substantially reduce costs associated with documenting and litigating “who thought of it first” questions.  It will also likely impede the formation and growth of innovative technology-driven startups in the United States. Whether that is a good trade off is something reasonable folks can disagree on.

The new “first to file” paradigm has some undeniable advantages; advantages that to some extent will have their most positive impact on smaller entrepreneurial innovators.  Historically, and I can attest to this from personal experience over 25 years of working with emerging technology businesses, the detailed record keeping programs associated with the first to invent paradigm trip up startups and smaller firms more often than they trip up the big players.  And even when a small firm has a plausible “first to invent” case, it often lacks the financial and other resources to make it effectively.

So much for the plusses of the new first to file paradigm. 

In terms of negatives, any good handicapper would have to say that startups and other smaller firms are going to lose more first to file races than they win, for two reasons.  First, they often lack the technical resources to move as fast as their larger and richer competitors in terms of taking an “aha” moment to a robust patent filing.  Second, they typically lack the deep pockets and intellectual property resources of larger businesses, which also make timely, robust filings problematic.  While the net negative impact on innovation by startups and smaller firms of the first to file paradigm can be debated, I have yet to see a cogent argument that the impact will be anything but negative.

As for me, I like the certainty – at least as to ownership – of the new first to file approach, and the likely reduced operating and legal costs associated with that.  And harmonizing United States patent law with the rest of the world has some intrinsic appeal.  Time will tell, though, whether those plusses are worth the price in terms of how the change will likely impact the amount of innovation in the United States.

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Entrepreneur of the Century or Company of the Century: Pondering Steve Jobs and Apple

August 29, 2011

By: Paul Jones

With Steve Jobs passing the reins at Apple (well, sort of: my guess is that he will be more active than the average Chairman of the Board) two main streams of analysis of the move have emerged.  On the one hand, there is the not unexpected almost worshipful take on his career and his genius.  On the other hand, there has been a pretty consistent message that “hey, Apple’s future is golden even without Steve”.  Does anyone else think these two messages – Jobs as Second Coming and Apple as continuing master of Wall Street – are a bit, well, incongruous?

 If Steve Jobs really is as brilliant as everyone seems to think (yours truly included) how can anyone seriously think that his departure from Apple will not herald a new era of diminished success for Apple?  I mean, Tim Cook seems like a good manager – even very good – but is he a genius on the level of Jobs?  If not, either Jobs being a genius wasn’t a material factor in Apple’s rising to the top spot in the business world, or, well, maybe he isn’t a genius.  But he clearly he is a genius. 

 Genius to genius hand-offs are in the real world are pretty rare, and it seems to me especially so when you talk about genius in terms of softer skills like design, vision and negotiating prowess – the kind of skills Jobs is justly heralded for; and the kind of things that are pretty much universally acknowledged as the foundation of Apple’s success.  (I can’t recall ever having read an article lauding Apple’s manufacturing prowess, or its financial engineering, though doubtless at least a few such articles have been written.)  Frankly, in the business world, none come quickly to mind, andMontanato Young and Favre to Rodgers in the sports world seem more like exceptions that prove the rule than repeatable models.

 Perhaps, though, there is a third alternative.  In “Outliers: The Story of Success” Malcolm Gladwell posits that truly exceptional achievers in any field are the products of a combination of great skill and great luck.  Anyone who knows the key twists in the emergence of Microsoft knows the peculiar mix of ability and good fortune that transformed Bill Gates from a modestly gifted programmer to one of the richest men in the world.  Maybe luck is the real story at Apple, not Jobs?

 I don’t think so.  For one thing, while I am sure Apple got some breaks over the course of time, I can’t think of any on a par with the break that came Microsoft’s way with IBM and DOS.  But even if luck was a big factor in Apple’s return from the dead under Jobs, does past good fortune make it any more likely that Apple can keep up the pace, so to speak, in the post-Jobs era?  Unlikely: getting lucky, by definition, is not (with due respect to the cliché that the harder you work the luckier you get) something you can plan for.

 So, it seems to me that if you can’t assume genius will follow genius, and that luck will follow luck, you can’t, I think, really believe that Apple’s success over the past decade can be repeated in the coming decade.  Just as it was, in 1997, absurd to predict that a struggling Apple would over the next dozen years go from needing a handout from Microsoft to overtaking Microsoft in the hearts, minds and pocketbooks of consumers and investors alike, so, I think, it is ultimately folly to predict that Apple’s success over the past dozen years will be replicated in the next dozen.  Check back in, say, 2022 and see if I am right.

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Pondering the First Mover Advantage

August 22, 2011

By: Paul Jones 

The so-called “First Mover Advantage” is one of those terms that invites both passionate devotees and passionate skeptics.  The “FMA” posits that an entrepreneur who gets to market first – with a novel technology or business model – has a sustainable competitive advantage over competitors that should predict ultimate victory.  It is a theory that explains a lot: Yahoo!, for example (or even Lycos, if you prefer).  Of course, it doesn’t explain Google quite as well.

The FMA was particularly popular in the internet bubble at the turn of the century.  In those days, convincing a venture capitalist that you had a real FMA would get an entrepreneur most of the way to a term sheet with most venture capitalists.  The term has been in and out of favor since; in when it seems to work, out when it doesn’t. 

My own thinking is that the FMA is a pretty good analytical tool in so far as it goes.  By that I mean that it is best understood as one-half of a much more instructive tool, which I will call the “First Mover with the Most Advantage” or “FMMA.”

Credit for FMMA probably goes best to Confederate Civil War General Nathan Bedford Forrest.  Forrest was a spectacularly successful cavalry general who won many victories over superior forces employing a strategy that he is famously remembered for saying was based on the notion that the force that “gets there first with the most” generally wins the battle.  That was almost always Forrest.

As applied to technology and business model innovation and success in today’s world, FMMA reminds entrepreneurs and investors that being first to market is by itself not the proverbially “sustainable unfair competitive advantage” that venture capitalists and business theorists are so fond of.  Getting to market first is quite often an unfair competitive advantage, but by itself it is not sustainable as such.  Being first to market with a new technology or business model is only a sustainable advantage if you get there with sufficient resources to capitalize on your position.

The real, but ultimately not unlimited, value of the FMMA tool can be seen in the development of the internet search engine business.  Going back to the 1990s, a number of search engines that look more or less like Google in terms of technology and core business model (Google has obviously broadened the model beyond basic search, as have its competitors, and the technology has evolved) got started, including Lycos, Infoseek, Magellan and Yahoo!.  Of these, Lycos could best stake the claim to the FMA in 1994.

But as history tells us – and the FMMA tool might have predicted – Lycos did not emerge as the winner of the first internet search war, but rather Yahoo! did.  Why?  Because Yahoo! was the first company to get to the market first with the most in terms of resources beyond basic technology and business model innovation.  Resources like superior marketing, and the most capital.  Resources that allowed Yahoo! to be the first of the first generation search engines to reach a critical mass in terms of brand recognition and value.

The Yahoo! experience tells us two things about the FMMA strategy.  First, the obvious one: that being first is not by itself enough.  You also have to be recognized and appreciated as such, and that takes another set of resources and skills, and generally lots of them.  Second, and if you keep in mind what happened to Yahoo! when Google came along, you will also see that FMMA can be a sustainable competitive advantage over time, but that as a tool it is only as durable as the management team that wields it.  It is only an advantage, not a guarantee. 

In terms of modern examples of FMMA at work, take a look at the ecoupon business, where Groupon can I think fairly lay claim to FMMA status.  It is clearly the big dog in terms of resources (brand recognition and value, as well as capital and revenues), and if the ecoupon business model has legs, Groupon would have to be the favorite to emerge as the dominant player.  But the favorite in a race still has to run the race, and run it well.  Favorite status is not a sure thing (Forrest got there first with the most and still, occasionally, came up short of victory; ditto Secretariat, the greatest thoroughbred of all time, who in fact did lose a race once).

In sum, the so-called First Mover Advantage is, for starters, incomplete.  Being first is great, but the advantage goes to the entrepreneur that gets there first with the most.  It is also an advantage that can be sustained – or not, depending on how well it is employed over time.

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