Growthink Blog

What Separates the Best from The Rest?


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Accelerant. C8 Medisensors. Dakim. DCIP. Free Conference. Fresh Games. Green Medical. Helix Wind. InfoSpace. Integreon. L3D3. Mobeze. MyPublicInfo. Nolatek. Ometric. Pocketsonics. Precision Time. Raise Capital. Recoup IT. Research Scientists. Sandel Medical. Spring Medical. Telverse. Thrombovision. XCOM Wireless. Xorbent.

These companies all share a few things in common:

1. They are either past or current Growthink clients and/or investments (though this is by no means a complete list).

2. They all either achieved - or are on the path to achieve - successful exits through a public offering or a company sale.

3. They are all led by CEO's and senior executives that are a cut above. Men and women that are entrepreneurs and business-builders in the best and highest sense - the kind of managers and visionaries that are the bedrock of America's vibrant, free enterprise system and way of life.

I have been privileged to work and get to know inspirational, entrepreneurial leaders like Dan Michel at Dakim, Liam Brown at Integreon, Walter Alessandrini at Ometric, Brian Ashton at Precision Time, Rick Singer at Raise Capital, Peter Sobotta from RecoupIT. Jack Smyth at Spring Medical Systems, Ed Teitel at Thrombovision, and Dan Hyman at XCOM Wireless.

Here are 5 qualities they all share:

1. Their Work Ethic is Off The Charts. This may sound really obvious, but the great entrepreneurs are extremely disciplined and organized and make the sacrifices to commit themselves fully to their business. Work - life balance is a nice theory, but in entrepreneurs to back, the more zealous the better.

2. They Have Great Numbers Fluency. As Guy Kawaski so eloquently puts it, we live in the age of excel, not of PowerPoint. Great 21st century leaders are "Super Crunchers," - they undertand the power of statistics, of "evidence-based" decision-making, of testing, and of managing by the numbers. They are not enslaved by the numbers nor do they lose sight of their human and qualitative aspects, but they are highly informed by them. They are hungry for unbiased, third-party information about their markets, their customers, their competitors.

3. They Have Done it Before. Following up on #2, the entrepreneurs most likely, statistically, to be successful are those that track records of success. It doesn't mean that just because they have succeeded in a past company mean that they will necessarily succeed in the next one. Nor do this mean that those who have failed in the past will fail in the future. Only that the probabilities are that this be the case. All of the managers above had track records before their existing business of successes - entrepreneurial successes, corporate successes, educational successes. Success follows them, not the other way around.

4. They Know When To Manage and When To Lead. Successful business exits require first and foremost, organization-building. Teams of people need to be assembled and directed to accomplish a common objective that can be quantified on the scorecards of business - revenues, profits, and cash flow. Balancing these left and right brain objectives require a sense of knowing when to manage and when to lead. Management is left-brained - it is analytical, numbers-driven, and dispassionate. It see business as a black box, with the sole objective of turning cash into more cash as fast as possible. Leadership is right-brained - it is conceptual, more long-term focused, and sees the business more as an organism as opposed to a collection of individual parts. Leaders sometimes will sacrifice short-term results for long-term gain, but do so carefully, deliberately, and warily. They are soft-hearted but hard-headed.

5. They are Proud and Humble. Great entrepreneurs are proud of their accomplishments and greatly desire more of them. They are confident in their vision and their abilities, and do not let adversity, criticism, objections or rejections deter them from their chosen path. They are not, however, headstrong nor arrogant. They respect facts, statistics, and informed opinions. And when these are in conflict with even their most dearly-held beliefs and strategies, they change. Not with the wind, but nor only at the point of a gun.

If you find these 5 attributes in an entrepreneur, savor them, appreciate them, learn from them, and back them. Till the cows come home. And then some more.


Angel Investors - Do You Want Venture Capitalists in Your Deals?


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The typical wisdom regarding the appropriate financing course for startup goes as follows:

  1. Founders start the company in classic "bootstrap" fashion - with a combination of sweat equity and their own financial resources. This usually consists of their personal savings, credit cards, and small loans from relatives (Mom, Dad, Uncle Bob, etc.).

  2. Through connections, or through a chance meeting at a networking or social event, an angel investor hears the entrepreneur's story, likes him or her and the technology, and on the spot, writes a check to provide the company with its first outside financing. The angel then introduces the entrepreneur to his or her wealthy friends and business connections who, based on the good reputation and respect that the angel has with them, also invest.

  3. With this capital, usually totaling between $100,000 and $1 million, the company accomplishes a number of key technical milestones, gets a key beta customer or two, and then goes on a "road show" to venture capitalists around the country. The first institutional financing round - usually between $3 and $10 million - is the first of a number of rounds of outside investment over a period of 3 - 5 years.  With this capital, the company propels itself to $50 million+ in revenues  and to either a sale to a strategic acquirer or to an initial public offering.

  4. With the exit, the entrepreneur and the original angel investor become fantastically rich (or in the case of the angel, even more so), and are lauded far and wide for their deep and keen predictive insight.

  5. The cycle is then repeated - the original angel investor utilizing the windfall from their successful exit to fund more companies.  And they are now joined in their investing by the once impoverished but now wealthy entrepreneur.

  6. All live happily ever after.

It all sounds wonderful and it is. The only problem is that it mostly a fairy tale. Here is what really happens:

  1. The entrepreneur pours their lives, their fortunes, and their sacred honor into their company- at great personal sacrifice to them, their families, and everyone connected to the enterprise.

  2. A "black swan" investor appears mostly out of the blue to fund the deal - less concerned re the efficacy of the technology than by the talent, desire, and grit of the entrepreneur. Technical progress and market traction are much slower and cost a lot more than anticipated. There are a lot of dark, hard days.

  3. There is considerable internal debate around whether or not to solicit and/or accept outside venture capital. For most companies, it is simply a non-starter. Management has the wrong pedigree, is geographically undesirable, competes in the wrong industry, and/or has a business model that lacks "scalability credibility" with the venture community.

  4. Usually unbeknownst to all, the conversation and decisions around pursuing or accepting a venture capital round above will be the factor most highly correlated with their expected return on investment.  But here is the key – contrary to popular wisdom it is negatively correlated.

New, groundbreaking research from the Ewing Merion Kauffman Foundation on Entrepreneurship shows that the #1 key for the angel investor returns in emerging technology deals is that there is never any venture capital invested in the company!

As interestingly, the data shows that when you remove a follow-on venture capital round from angel invested deals that expected returns skyrocket.

The data is somewhat inclusive as to why this is.  I surmise three main reasons:

  1. The Best Metric for the Health of A Company is Cash Flow. By definition, companies that receive venture capital cannot fund their businesses from operations - and thus need to seek outside capital. This may lead to inherent negative selection to venture deals – whereby the sample of companies that need outside capital are by definition weaker companies.  

  2. Venture capitalists Have Very Different Objectives than Angel Investors. Venture capital funds are usually 7 - 10 year partnership structures whereby the general partners, the VC’s, manage the capital of the limited partners, usually institutions (endowments, pension funds, etc.).  And at the end of the period, all profits and proceeds are distributed to the various partners on a pre-determined split. These splits are normally such that the general partner professional money managers need to obtain a “highwater” return for their limited partners before they, as the general partners, see any return. beyond their management fees   In practice, this creates a huge incentive for the general partners to hold on for home runs, and to be reasonably indifferent regarding smaller (less than 3x returns).  As a result, the VC will often block a portfolio company from harvesting a very attractive, but not a home run, investment return. Or as counter-intuitively, press for a far more risky strategy than the entrepreneurs or the angel investors in the deal would prefer.

  3. Venture capitalists Cut Tough Deals. Venture capitalists for the most part are very nice guys and passionate about entrepreneurship, but they are not shrinking violets. And they hire very aggressive securities attorneys to represent their interests.  This combo all too often leads to various forms of deal unpleasantness -  ncluding cram-down rounds, liquidation preferences, and change of control provisions, among others. Which in turn often leads to a lot of very unhappy founders and angel investors even in somewhat successful exits.

My suggestions for the angel investor looking to make money?  First, look for "one and done" deals - companies that need just one round of outside capital to get them to positive cash flow.  Second, look for companies that have short and realistic liquidity (exit, IPO) timelines.  And third, don’t get star-struck by big VC interest in your deal.  It can often be a double-edged and very sharp sword.   


The Stock Market Rebound: What Does it Mean for Angel Investing?


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With the Dow Jones up more than 35% from its early March lows of 6,440, the investing mood has undergone a 180 degree turn for the better. How does this rebound affect the angel investing returns?
Here are the negatives and the positives:

The Negatives:

  • A Zero Sum Game. On some levels, assets classes compete in a zero-sum game for investor attention. So with money moving back into the real estate market, with long-term treasury yields creeping up, and with the increasing attractiveness of traditional stock mutual funds ticking up, the risk-reward profile of private equity (of which, of course angel investing is a class) are relatively less attractive.

  • The Bad Behaving VC Older Brother. Venture capital performance over the past 10 years has been shockingly bad, with some estimates being that the entire asset class has had ZERO return since 2000.  And so many assume that as venture capital returns goes, so go angel investing returns.  While the actual return statistics actually show the opposite (Data compiled by the Kaufman Foundation, by Ibbotson Associates, and by The Economist, show a 25%+ 10-year average angel investing return performance), perception is too often reality and is sometimes self-fulfilling.

The Positives:

  • Venture Capital Returns ARE Improving with Improving Public Markets. Having said the above, return expectations for venture capital are looking up.   Why? Because the IPO market is in an early boom period with the big recent market move.

  • America is Returning to its Natural State: Deal making. One of the worst aspects of the September–March market “darkness” was the unprecedented crisis of business and financial confidence it precipitated. The mood in America – the land of Vanderbilt and Rockefeller and Edison and Watson and Walton and Gates and Jobs and Brin and Page – felt like, I am very sorry to report, France. The end-of-the-worlders were in their full bloom, and for once, the facts on the ground seemed to agree with them.
But we are getting our groove back. Consumer and business confidence have skyrocketed since March. Bank lending is up. Business capital expenditures are increasing. The real estate market, in most parts of the country, has at least stabilized (and in many places, greatly rebounded). Jobless claims are down. Most importantly, corporate profit forecasts are up.

All of this drives deal-making. It drives big companies to buy small companies to gain access to their people and their technology. It drives venture capitalists to agree to bridge financings. It drives entrepreneurs to get back to pushing the envelope with their growth plans. And all of this positive, forward-looking acting and thinking drives angel investing returns. Entrepreneurs grow their businesses faster, they exit faster, and investors turn their money faster and at great multiples.
All these factors have turned 180 degrees since March. And for those that love America and its entrepreneurial spirit, not a moment too soon.

The Early Exit


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The next big private equity investment idea is the “Early Exit.” The best articulation of it comes from Basil Peters, a serial technology entrepreneur, co-Founder of Nexus Engineering, former Canada Entrepreneur of the Year, and Managing Partner at 3 venture capital funds – Fundamental Technologies I and II and the BC Advantage Funds. His blog is one of the best resources on technology investing out there.

Aptly to the point, Basil is the author of a great new book – “Early Exits: Exit Strategies for Entrepreneurs and Angel Investors.” His core thesis is that successful private equity investing is now driven by quickly getting to the smaller investment exit.  Or, as he says it, "Today, the optimum financial strategy for most technology entrepreneurs is to raise money from angels and plan for an early exit to a large company in just a few years for under $30 million."

I love this strategy because it is realistically attainable for the individual investor. Here's why:

You, Mr. or Ms. Main Street Investor, are NOT getting a piece of the next big IPO: The 2 best known venture capital funds –Sequoia Capital and Kleiner Perkins - because of their reputations and massive bankrolls – will continue to get the lion’s share of the deals with rockstar IPO potential. Try these names on for size – Electronic Arts, Apple, Google, NVIDIA, Rackspace, Yahoo!, Paypal, Amazon.com, America Online, Intuit, Macromedia, Netscape, Sun Microsystems.
They were all Sequoia and/or Kleiner investments that became mega-successful IPOs. To give a feel for the power of their investment model, estimates are that Kleiner’s investment in Amazon scored returns of 55,000%!

YOUR big problem – your friendly neighborhood stockbroker (if they exist anymore) isn’t getting you in on any of these deals anytime soon.  And if you don’t have a $100 million bankroll and the very right connections to become a Kleiner or Sequoia LP, you’re not joining their club.

Hit’em Where They Ain't:
The size of most modern venture capital funds has increased, with the average sized fund now having more than $160 million under management. As a result, the vast majority of professional investors simply can’t and won’t invest in smaller deals. The new VC model has, for better or for worse, become “Go big or go home.” As such, competition for smaller deals is much less and the deal pricing on them far more favorable.

Small Deals Rock:
You don’t need a lot of money anymore to build a technology startup – not with outsourcing, viral marketing, and the Software as a Service (SaaS) revolution. And if your business isn’t cash flow positive REAL FAST, you probably don’t have a very good business.

So the new technology investment model is to place small amounts (under $1 million) into companies that a) develop intellectual property and compete in markets with lots of active strategic acquirers (think Internet, software, biotechnology, digital media, and energy) and b) have management with the mindset and track records to ramp-up and exit FAST and at very attractive but not pie-in-the sky multiples. 

Not a game that big private equity or venture capitalists are interested in playing because it is just too hard to put large amounts of money to work in such a fragmented marketplace.
But if done right, an EXTREMELY lucrative one for thoughtful entrepreneurs and the investors that back them.


Here Comes The Sun


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In my role as the CEO of Growthink, I get asked variants of the same questions a lot, namely:  "What do you think about this economy?”  “Do you see things turning around?” “Are there any deals getting done out there?”  I answer these questions based on a number of factors:

  • How is the Dow Jones Doing?  While the performance of the index of the 30 biggest industrial companies is no way near as indicative of the health of the U.S. economy as is popularly imagined, it has enormous psychological importance.  While still massively off its highs, the trickle-down benefits of the market moving to its current 8,300 level from its March 9th low of 6,440 (an uptick of 29%) cannot be overstated.  If we can see the rally continue to the 10,000 level by the end-of-the-year, we can declare this recession officially over.

  • How is Consumer Confidence?   The Conference Board’s Consumer Confidence Index this month jumped to an 8-month high in May, spiking from a 40.8 level in April to 54.9.  The index had hits its lowest level in February (25.3) since tracking began in 1967.  As Lynn Franco, the Conference Board's research director, said "While confidence is still weak by historical standards, as far as consumers are concerned, the worst is now behind us.”

  • What is The Level of Venture Capital Funding Activity?  Venture capital funding activity in the 1st quarter of 2009 hit its lowest level since 1997, with venture capitalists investing just $3.0 billion in 549 deals (National Venture Capital Funding Association).  Signs are very strong that the 2nd quarter will be appreciably better, with the buzz created by the $10 billion valuation on a $200 million investment in Facebook by a Russian investment firm adding significant buoyancy to the overall emerging technology company arena.

  • How is the IPO Market Trending? The successful IPOs of venture capital-backed companies OpenTable, the online restaurant reservation service, and SolarWinds, a network software company are contributing long-awaited liquidity and bull market sentiment to the long-suffering IPO market.  Big valuations and big money being made by early investors in deals like this is what angel and venture capital investing are all about – so see more IPOs like these coming down the pike in the near future (Twitter and LinkedIn, anyone?)

  • How is Growthink Doing?  Because as a firm we touch so many entrepreneurs and angel investors every day, our business and investment activity has historically been a very good leading indicator of overall economic activity and equity investment performance.  And after going through the most challenging 6 months in the history of the company from September through March, business has picked up significantly. May 2009 already has been Growthink's best revenue month since last summer, and our deal pipeline is right now the strongest it has been since late 2007.

 

What does this all sum up to?  The Beatles say it much better than I ever could:

Little darling, it's been a long cold lonely winter
Little darling, it feels like years since it's been here
Here comes the sun, here comes the sun
and I say it's all right


The Future IS Ours To See


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"Those who cannot remember the past are condemned to repeat it" - George Santayana

The financial panic of 1873, which set off a severe nationwide economic depression that lasted for 6 years, included The New York Stock Exchange closing for 10 days, 89 of the country's 364 railroads going bankrupt, and unemployment as high as 14%.  During this extremely challenging time, a gentleman by the name of Thomas Edison started a company called General Electric. You may have heard of both of them.

The Great Depression of the 1930's is even scarier in statistics than in legend.  Industrial production fell by 45% between 1929 and 1932. Homebuilding dropped by 80%. 1,000 of the nation's 25,000 banks failed. US GDP fell by 30%. 

And during these dark days, DuPont created new products and indsutries including rayon, enamels, and cellulose film. RCA invented television.  And a little company called IBM started pouring research dollars into something called the computer.

The 1970's are commonly remembered as a dark period for American finance and business - stagflation, negative stock market returns for the decade, and hits to the national psyche including Vietnam, Watergate, and the Hostage Crisis.  It was also the era that 2 ambitious and visionary young men named Bill Gates and Steve Jobs got their start.

My 20 years in angel investing, small business and entrepreneurship have taught me to separate the world into two kinds of people: Those that comment and complain on how things are and those that do something about it.

Unluckily for all of us, television and the always on Internet give those that comment and complain bigger megaphones than ever to spread their false prophesies of doom. It is only human nature to be affected, depressed, and even scared by their strident negativity.

Very, very luckily for all of us, however, there always be budding Bill Gates and Steve Jobs and Thomas Edisons and Thomas J. Watsons amongst us. And where are these future shining stars devoting their prodigious energies to these days? I promise you that most of them aren't working at General Motors, nor are they drawn to politics or working in the public sector, nor to non-profits.

No, they are capitalists. They are entrepreneurs.  They start and work at Internet companies, they research alternative energy technologies they discover new drugs to make us all live longer and healthier lives. They are and they discover Black Swans.  They - in the words of Voltaire - make "life throb to a swifter, stronger beat."  

And you know what else? They're in it for the money. They want to build companies like Pure Digital (makers of the FlipCam) did and sell out to Cisco Systems for $590 million.  Or Facebook, on the verge of a public offering that will make its early investors billions. Or Integreon, whose business plan was perfected in a small Growthink conference room 10 years ago, and is now the largest legal outsourcing firm in the world (and saving a lot of folks a lot of money on their legal bills).  

With apologies to Doris Day, the future is in fact ours to see. As long as little boys and girls are raised to grow up to do something great with their lives, progress will march on.  Technologies will be commercialized.  New industries will arise.  Companies will be born and will grow and grow and grow. Fortunes will be made.  

The question, of course, is what will be in it for you? Will you be on the couch with the critics? Or will you be in the game with the builders and the doers?


These Truths About Angel Investing Will Surprise You


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Scott Shane, one of the world's most respected statisticians regarding entrepreneurship and angel investing, has a new book out - "Fools Gold? The Truth Behind Angel Investing in America."  It is without question the finest compilation of statistics and cold, hard facts regarding the REALITIES - as opposed to the myths - of the keys to successful angel and emerging company investing.  Some amazing statistical nuggets from Scott's book:

  • The book's 12 chapters have a combined 692 source references!  Compare this to the average "this is what I think with absolutely no basis in numbers" opinions that pass for wisdom on CNBC, on the world of Internet financial blogs, and from your friendly neighborhood financial advisor
  • Average portfolio return for angel investors participating in organized angel groups: 27% annual return (quoting this study)
  • Return expectation per deal for investments by successful angels: 30x
  • Proportion of business angels that expect a 10 times or better return: 45.4% (what they actually get is another matter...)
  • Number of companies founded each year that achieve $10 million or more in sales in 6 years: 3,608
  • Number of companies founded each year that achieve $100 million or more in sales in 6 years: 175
  • Share of drug start-ups that go public: 20.3%
  • Portion of venture capital dollars invested in the top five industries for venture capital: computer hardware, software/Internet, semiconductors and other electronics, communication (including mobile) and biotechnology - 81%
  • Top reasons why people invest in private companies:  To make money (obviously), to learn new things, to pay it forward
  • Number of companies financed by business angels in a typical year: 50,700-57,300
  • Amount invested by business angels in a typical year: $23 billion
  • % of Angel Investors with net worths of LESS than $1 million: 66.7% (really an amazing statistic as the SEC definition of an accredited investor is a person with a net worth of greater than $1 million)
  • 45 to 54 - Age range with the highest odds of making angel investments - disputes the myth that most angel investor are retired
  • Proportion of angel investments that involve co-investment with VCs - less than 1.1 percent
  • Proportion of angel investments made in retail and personal service businesses - 37.5 percent.  (Note: If you just make a rule to NOT invest in these 2 areas, your probability of emerging company investing success goes up dramatically)


As working with and investing in entrepreneurial companies is my life's work, I read this book extremely closely and found it both invigorating and challenging.  Invigorating in that it confirmed, with statistics, the superiority of private company investment returns vis a vis all other investment classes.  And frustrating in that it starkly outlines the very basic mistakes that most private company investors make over and over again that prevent them from being a successful investor in this asset class.

My overall takeaway: If you want to invest in private company deals, only do so via one of two avenues: 1) Via a GOOD angel investment group like The Band of Angels or the Tech Coast Angels (if you can get in) or via a managed portfolio approach such as a private equity or venture capital fund targeted toward the space or via a hybrid, operational approach like Growthink.


Where to Find Alpha


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Adobe. Akamai. Amazon. Amgen. Apple. Baidu. Bed Bath & Beyond. Biogen. Broadcom. Check Point. Cintas. Cisco. Citrix Systems. Dell. eBay. Electronic Arts. First Solar. Flextronics. Garmin. Genzyme. Gilead Sciences. Google. Hansen Natural. Infosys Technologies. Intuit. Juniper Networks. Logitech. Maxim Integrated Products. Microsoft. NVIDIA. Oracle. Paychex. QUALCOMM. Research in Motion. Seagate Technology. Sigma-Aldrich. Starbucks. Symantec. Urban Outfitters. VeriSign. Xilinx. Yahoo!

What do these companies have in common? Their stocks are all components of the NASDAQ 100 – the “biggest and the best” of the mostly technology-focused companies that make up the overall NASDAQ Composite Index.

Quite simply, this is a list of some of the most dynamic, most innovative, most technological, most forward-thinking, highest “IQ” companies on the face of the earth.

And know what else? If you had been invested in any relevant basket of these stocks in the last ten years, your investment returns would have been HORRIFIC. Here are some sample returns:

In the period from January 1st, 1999 to December 31, 2008, the overall NASDAQ composite index went from 2,192.69 to 1,577.03, or a 10-year return of MINUS 28.1%. Microsoft, down -45%, Yahoo down 71%, Akamai down 86%. Even the winners haven’t down all that hot – Starbucks up only 18% for the decade. Electronic Arts – riding the global gaming wave – up a pretty mediocre 52% for the whole decade.

So the obvious question is - what is going on here? The companies on this list have certainly been innovating and growing these last 10 years. And the #’s here are not overly distorted by the bubble of 1999-2000 and the great crash of 2008. If you normalize for these two factors, the numbers are somewhat better, but still no way NEAR the mid-teens annualized returns that the mutual fund and insurance industries would like you to believe you will get via a standard basket of public stocks investment approach.

Like Mickey Rourke’s character in “The Wrestler,” the stock-picking industry can’t keep themselves from talking about their glory days of the 1980’s and 1990’s. These two decades saw consistent double-digit broad public stock market returns.  In those days, making good, and sometimes great returns, was as simple and easy as buying virtually any index or broad-based market index fund. To illustrate this, let’s look at the NASDAQ return by decade:

  • In the period from January 1st, 1979 to December 31, 1988, the NASDAQ returned 223%. And in 6 years during this 10-year period, the index returned greater than 14% annual returns.
  • In the period from January 1st, 1989 to December 31, 1998, the NASDAQ returned a whopping 475%. And in 8 years during this 10-year period, the index returned greater than 14% annual returns.
  • In the period from January 1st, 1999 to December 31, 2008, again the index returned a depressing -28.1%, with only 2 years (1999 – with a whopping 85.1% and 2003 with 50.01%) returning greater than 14%.


What is interesting, however, was that the last 10 years – the “00’s” – were far, far from a lost decade for the professionals. In fact, while the Main Street investors were left holding the bag, the hedge fund and private equity businesses boomed. Little and sometimes well-known money managers like Bruce Kovner, Edward Lampert, Eric Mindich, George Soros, James Simons, Louis Bacon, Marc Lasry, Paul Tudor Jones, Ray Dalio, Stephen Feinberg, Stephen Schwarzman, Steve Cohen, Steve Mandel, T. Boone Pickens and William Browder earned personal compensation packages that regularly exceeded 10 figures – as in billions of dollars of earnings. And to make it even more of a kick, when the bottom fell out these last 6 months, they didn’t have to give back all of the money they had personally earned over those years. No, conveniently those losses were born by a combination of their investors and the American taxpayer. Nice gig if you can get it.

So what does this all ad up to? A few action points:

  1. NASDAQ market investing is NOT emerging company investing. By the time these companies earn the kind of attention, trading volume, and brand to be NASDAQ-listed, it is simply too late to make breakout returns investing in them. 20 years ago, maybe. But today the combination of free-flowing information sharing in these stocks and having to compete with huge hedge fund players like the above, you don’t stand a chance.
  2. As the famed batsmen Wee Willie Keeler once said about his hitting prowess, I just “hit ’em where they aint.” To make any investment return beyond the averages, you have to fish where the sharks above aren’t. You won’t beat them and unless you have $10 million liquid, you don’t have enough money to join them.
  3. Luckily there is a MASSIVE investing arena where a) the big guys aren’t and b) where market efficiencies haven’t sucked out all of the opportunity for alpha return. It is, of course, the emerging and distressed private company sector. Most of the deal sizes here are simply too small for the big institutional players (hard to put a $1 billion to work in an owner-operated private company). And if you work hard and know where to look, you can exploit a LOT of market inefficiency and find those wrinkles of alpha return that will transform your portfolio.

What is an Emerging Company?


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Over the years, descriptions, or "boxes," for various type of privately-held companies like "middle market," "venture-backed," "startups," "small and medium-sized enterprises (SME's)," to name a few, have been tossed around so much as to obscure and confuse their original meaning and intent.

This is highly unfortunate, as it creates opaqueness and inefficiency in an asset class already plagued with too much of both.

Let's leave the official classifications aside for now and focus on developing an identification process for the kinds of private companies that are worthwhile for the growth investor to consider for their portfolio.

At Growthink the catch-all term we use for the private companies we like best is "emerging." It does not suffer from "commentary fatigue" as do private equity and venture capital, and it effectively carves out the large mass of startups and small businesses destined to stay small.

Webster defines "emerging" as follows:

1. To rise from an obscure or inferior position or condition
2. To rise from or to come out into view
3. To become manifest
4. To come into being through evolution

Let's elaborate on these definitions in the context of an investable company.

1. To Rise From an Obscure or Inferior Position or Condition: Emerging companies are, in their most common and interesting form, small and obscure. Microsoft and Google were once just a small group of programmers and were deep under-the-radar. And if you were invested in them then, your life changed dramatically for the better as they emerged. Less famously but still extremely lucrative were companies like the below that emerged to significant exits for themselves and their investors:
  • About.com: acquired for $410 million by the New York Times
  • Advertising.com: acquired for $435 million by AOL Time Warner
  • Affinity Labs: acquired for $61 million by Monster Worldwide
  • AllBusiness.com: acquired for $55 million by Dun & Bradstreet
  • Aruba Networks: IPO at a $1 billion valuation
  • Club Penguin: acquired for $350 million cash (and possible $350 million earnout) by Disney
  • FraudSciences: acquired for $169 million by PayPal
  • Glu Mobile: IPO at a $371 million valuation
  • Last.fm: acquired for $280 million by CBS
  • Mellanox Technologies: IPO at a $579 million valuation
  • Orbital Data Corp.: acquired for $50 million by Citrix Systems
  • Overture: acquired for $1.63 billion by Yahoo!
  • Photobucket: acquired for $300 million by Fox Interactive Media
  • Speedera Networks: acquired for $130 million by Akamai
  • Skype: acquired for $2.6 billion by eBay
  • The Generations Network: acquired for $300 million by Spectrum Equity Investors

2. To Rise From or To Come Into View: Emerging companies are often ones that have fallen on hard times and are seeking to "rise from" their current distress via turning around and restructuring their businesses. The banking and real estate sectors are right now treasure troves of fantastic distress and turnaround opportunities, as are arenas like publishing and the automotive industry.  As adversity intensifies, so does emerging opportunity.

3. To Become Manifest: Here we need Webster's help again - to become manifest, or to be "readily perceived," or to be "easily understood or recognized." Emerging company businesses are SIMPLE businesses. They make things or provide services, and sell them for more than they cost to make or deliver. And every quarter and every year, they just "chop more wood" and "carry more water," and thus drive revenue and earnings growth. It usually isn't fancy nor often even terribly interesting. But it almost always is easy-to-understand and recognizable in the company's financial statements. An important note here is that emerging companies, contrary to popular belief, are usually NOT venture capital-backed companies. Why? Because they don't need to deficit finance their businesses because they are cash flow positive. In fact, the very sign that a company needs outside financing (see GM, AIG, et al.) is often the best sign that it is NOT an emerging company because they can't make any money. 

4. To Come Into Being Through Evolution: This is perhaps my favorite because it references the essence of any business - the talent of its people and the quality of its corporate culture.  The best emerging companies are always run by a group of hard-working, thoughtful, creative, persistent, and fantastically committed owner-operators. They devote their lives to their businesses for multiple, non-contradictory motives. They want to offer true value to the marketplace with their product and service offerings. They want to leave a legacy via building enterprises of lasting value and character. And they want to make a lot of money. Accomplishing these 3 objectives in a big way involves a lot of trial-and-error and a lot of figuring out all of the ways not to invent the light bulb. While popular business culture is fascinated with the "golden boy entrepreneur" stories (i.e. Microsoft and Google), these are much more the exceptions than the rule. Far more common are stories like Amazon, Kinkos, The Body Shop, Outback Steakhouse, or even Wal-Mart and Hewlett-Packard - companies that had reasonably long gestation periods, and a lot of slow or no growth periods, before evolving to successful forms. And then continuing to evolve as market and competitive conditions dictate.

If you are a fundamental investor, look for the above qualities in companies you are considering for your portfolio.  Look for them quantitatively with the key metric of operating cash flow growth (everything else is subject to accounting whim) and look for them qualitatively in the mindset of management and in the tenor of the corporate culture.  If both the numbers and the business tone align and you can get in before the whole world knows about it, then you have yourself a money-maker.  Or, another way of saying it, an emerging company. 

Idealistic Capitalists


Categories:

Investing in startups and emerging companies is the process of identifying and backing the entrepreneurs and executives with the best ability to move efficiently and profitably from ideas to execution, and then from execution back to ideas and then back to re-focused execution. And finding those that do so on all aspects of their businesses -- marketing and sales, operations and finance.

The entrepreneurs to avoid are those overly focused only on ideas or only on execution. Those focused only on ideas often let the desire for the perfect negate the doable.  They don’t quickly and rigorously subject their ideas to the rumble and tumble of the marketplace. Here we are referring to the great idea person that never gets around to actually executing upon an action plan. 

On the other hand, those entrepreneurs focused on just execution, while at some levels far more effective than the ideas set, are often too slow to react to changing technological, marketplace or competitive conditions. They often define their value offerings so narrowly that they miss adjacent opportunities. Classic examples of this include IBM defining themselves as a computer hardware as opposed to a technology solutions company in the 1980s, thereby ceding the operating system software market opportunity to Microsoft. Or the traditional phone companies in the 1990’s not leveraging their huge patent portfolios to profit in the emerging mobile communications and Internet marketplaces.

Contrastingly, the best entrepreneurs and successful executives are constantly finding the balance between ideas and execution. They are masters at what we at Growthink like to call, “The Business of Ideas.” They are both creative and task-focused, but not too little or too much of either. They make plans and they work them, but they are not slaves to them. They understand that great businesses are inspired by ideas, but their success is counted in cash.  They are, in essence, “idealistic capitalists,” believing that the best ideas, the best products, and the best services make the most money.

Entrepreneurs running businesses like these are few and far between for sure. But when it all comes together, legends are born and fortunes are made.


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