Category: Blog Articles

Interview with Angel Investor Esther Dyson

Posted on by Anna Walker

Last semester, Esther Dyson, an angel investor focused on health, biotechnology, and space flight innovation, was featured as a keynote discussion sponsored by the Telluride Association. After Ms. Dyson shared snapshots of her experiences, including her work as a journalist on Wall Street and her completion of cosmonaut training for a future space flight, I invited her to share some of her perspectives on investment with our readers. The following is an edited version of our conversation.

When did you start investing in startup companies?

To give you some background first, I started working as a fact-checker for Forbes. That provided tremendous training for all my work – perhaps the best training you could have – in asking the right questions, and being properly skeptical of the answers. I worked for Forbes for three years and then worked as an analyst on Wall Street for five years. Next, I worked for Rosen Research and bought the company, renamed to EDventure. I wrote its monthly newsletter about the computer industry, and ran its annual conference (PC Forum) from 1982 until 2006. That’s where I learned the most about computers and the internet.

Then, in the early ‘90s, I started spending a lot of time in Eastern Europe. An investor said to me, “Considering the amount of time you spend in Eastern Europe, why don’t you invest?” I had never thought of that; I was a journalist. But, when he offered me $1 million to invest, I closed down my Eastern European newsletter and started investing instead. I learned a lot from these early investments, including how much fun it could be. I started investing in United States startups as well.

You mentioned in our correspondence not having an MBA. Was it difficult breaking into the financial industry without this degree?

An MBA makes it easier to find a job, yes. But once you get the job, it all depends on how well you do it and whether you can learn.

When someone on Wall Street looked at your resume and asked, “Why no MBA?” what did you say?

I told them I worked as a fact-checker and reporter for Forbes for three years, and that I understood business from the players’ rather than from the professors’ side.

What other characteristics do you believe make you a good investor?

Curiosity and enthusiasm. I love what I do! I would love to make money with my work, and I am glad when I do – and of course I need money to keep investing. But for the most part, I don’t do anything I wouldn’t do for free. Fortunately most of it pays off anyway!

How important is it for investors to share ideology with the company receiving their investment?

Oh, very important. When you need to make a tough decision for the company, it is important to have your interests aligned. Startups should be selective when it comes to picking their investors because their investors end up having a big say in the company’s direction.

Do you use investment to promote or change public policy?

No. It’s hard to change public policy. In fact, I am very frustrated with Congress and both political parties. I use investment to do what I can to help companies, ideas, and people fulfill their potential. I do get involved in policy, but not usually through my investments. Unfortunately for most companies, the less they have to do with policy the better – at least until they grow quite large.

What role should public policy play in investment?

It depends on what the policy is. Generally, the best policy for free markets is antitrust enforcement. Competition and transparency are crucial for building companies and fostering success of the best players. Maintaining consumer choice is also important.

Most markets work well. If you introduce public policy in the market, such as subsidies for health care, you should make sure the policy has no adverse side-effects. Moreover, these policies should be clear, transparent, and have discrete objectives. For example, it’s usually better to subsidize people rather than specific products. You can help the poor or the ill without interfering with their ability to choose. Though I would support policies such as prohibiting the purchase of cigarette or soda pop with food stamps.

For me, areas in need of public spending are health incentives – not just health care – education, and our country’s infrastructure, such as roads and bridges and mass transit.

Thinking about your involvement as a board member for 23andme, what role should public policy play to protect privacy? For example, should public policy protect privacy over consumer health information?

The government should foster clarity and informed consent, and leave privacy choices to individuals. People should have access to their own data and retain control over whom to share it with. However, if individuals want subsidized health care, they have certain obligations to provide accurate data to be used in the context of that care – but mostly not in the context of an employer making job-related decisions.

The problem, however, is not privacy. The problem is how the data may be used and society’s overall economic and health-related policies. I would hate to see people with diabetes being charged an extra tax on junk food, for example.

Unfortunately, we are conflating economic issues, such as who should pay for health care and what they should pay for, with privacy issues, such as what health information individuals should be required to reveal and to whom these disclosures should be directed.

How should companies properly use the data they receive from consumers?

They should use it only in the way they have contracted with the user to use it.

Switching gears a little, and in closing, what are your most memorable accomplishments?

First of all, I like to say that I’m not done yet. I don’t sit around and think about everything I have done. I am proud of having trained as a cosmonaut and I am proud of being one of the first ten to publish my DNA with the human genome project. I am also proud of 23andme. But there are so many things I still need to learn and to do.

For more information about Esther Dyson please visit EDventure Holdings or check out her contributions on Project Syndicate.

Bad Apples Spoiling the Crate?

Posted on by Joseph R. Morrison, Jr.

The New York Times “Bits Blog” had an article this past Sunday titled “Disruptions: Tech Valuations Defy the Restraints of Reality.” Unfortunately, this short read paints a broad brush of the Venture Capital industry and plays to a few of the oft-discussed and unflattering stereotypes about venture capitalists (…as if there was any need for fuel to be added to the raging fire stoked by Republican presidential candidates.)

The article lays out a number of problematic investment rationales pursued by some within the VC industry. Among the rationales listed are:

• Investing only based on a “herd mentality and a yearning to be a part of a potential next big thing”
• Investing in a company “so they can stick the logo on their Web site”
• So-called “spite investing” when you invest in a company “simply because they were not given the opportunity to invest in the competitor”

Do these practices go on? Clearly they do, which is why the failure rate of venture capital firms can exceed 50% during some periods (per the Harvard Business Review) and so few earn solid returns on investment. However, it would be unfortunate to paint the industry with such a broad brush. The few bad apples with money to spend, but not the sense to invest it wisely, should not pollute the image of an entire industry.

A number of successful (and tenured) VCs have spoken in classes at Michigan, and they have consistently preached the polar opposite of the approaches noted above. Their principles are simple: don’t follow the crowd, be true to your investment analysis methodology, and be steady in how you invest your money. Quite apart from the investing process described in this article, these VCs described the process as akin to “courting a significant other” in order to become personally close with the founders. They also spoke of the industry’s increasing talent. Many VCs have built their own companies or have been executives at Fortune 100 companies.

Will that approach counter the ills described in the Bits blog? It will not. If it did, everyone would be taking the same approach in an industry notorious for breaking the mold. However, those principles will help you avoid turning a venture capital portfolio into a junkyard of failed investments and, apparently, it will also prevent you from running with the rest of the herd (50% of which won’t see its next meal).

In the post dot-com crash and Sarbanes-Oxley world, companies are staying private longer. This allows companies to develop into real revenue-generating businesses without being scrutinized by public markets. The days of “pets.com” are history and also the irrational exuberance that came along with them. VCs that succumb to irrational investments fail, as they should. So, while the article seems to paint the whole lot as a bunch of crack pots, the truth is that the industry is full of extremely successful investors. Otherwise, why would there be so much money entering the market in first place? Success breeds copycats.

NYT article: http://bits.blogs.nytimes.com/2012/01/22/disruptions-the-sloshing-sound-of-tech-valuations/?ref=business&nl=business&emc=dlbka34

HBR article: http://hbr.org/product/risk-and-reward-in-venture-capital/an/811036-PDF-ENG

University of Michigan Adds Venture Capital Fund within Endowment

Posted on by Joseph R. Morrison, Jr.

The University of Michigan Board of Regents has approved a University-housed and managed venture capital fund.

The permanent allocation, part of the $7.8 billion endowment, will be called Michigan Investment in New Technology Startups (MINTS). The $25 million fund will be invested over 10 years and be co-managed by the University’s Office of Tech Transfer, a department that manages and funds technology spin-offs, and the Investment Office, which manages the University’s long-term endowment fund.

The Office of Tech Transfer has spun off a number of prominent venture capital-ready investments, as is recognized by Dr. David Brophy’s “Financing Research Commercialization” course at the Ross School of Business. The creation of this fund is further acknowledgement that the Office of Tech Transfer is going to be a growth engine for the University and that this technology center will be profitable enough to be worthy of the University’s investment attention.

The initial investment may seem small, but this fund will allow the University to make several small-to-mid-sized investments per year, a number that would be about average for a new fund in this area.

One can only hope that the creation of this fund will attract other venture capital firms to increase their focus on Michigan. Additionally, this new fund will provide students in the Zell Lurie program and the Ross School of Business a vehicle through which they can receive early exposure to venture capital investing. What a great development for the University and southeastern Michigan.

http://www.pionline.com/article/20111229/REG/111229904/university-of-michigan-to-start-venture-capital-fund

Private Equity Firms Continue to Utilize Material Adverse Effect Provisions as a Device to Force Sellers to Renegotiate Agreements

Posted on by Daryl L. Saylor

A Material Adverse Effect (“MAE”) is a provision that is included in a negotiated agreement to allocate risk between a buyer and seller during the period separating signing and closing. A pro-buyer MAE will provide the buyer with the ability to walk away from a transaction if there is a material adverse effect; whereas, a pro-target MAE will make closing of the deal fait accompli.

An example of the standard MAE is: “There shall not have occurred a Material Adverse Effect on the Company.” Consequently, the provision acts as a mechanism to protect the buyer from the occurrence of unknown events, which threaten the long-term health of the seller’s business. Sellers, however, will want to attenuate the provision’s applicability by requiring there to be certain carve-outs. For example, the seller may exclude from the definition of a MAE “Acts of God, earthquakes, hostilities, acts of sabotage or terrorism or military actions or any escalation or material worsening of any such hostilities, acts of sabotage or terrorism or military actions.”1 Otherwise buyers would be able to walk away from a deal under their own economic discretion.

Indeed, the chronological progression of MAE disputes have become all too predictable over the course of the past decade: (1) a buyer and seller reach a negotiated agreement that includes a MAE; (2) the buyer walks away from the agreement claiming that there has been a material adverse effect as a result of a change to the sellers business, assets, liabilities, operations, conditions or prospects; (3) the seller files suit asserting that the buyer improperly terminated the binding agreement; and (4) instead of progressing through trial, the buyer and seller renegotiate the purchase price (or some other remedy that is favorable to the buyer’s position), resulting in a settlement and dismissal of the lawsuit.

This is precisely what happened in In re Innkeepers USA Trust v. Cerberus Series Four Holdings2, which follows the recent trend of private equity firms using MAEs as an effective tool to force renegotiation and strike better deals for its stakeholders.3 Innkeepers filed suit against Cerberus and Chatham on August 29, 2011 for walking away from its $1.12 billion deal to purchase multiple hotels owned by Innkeepers. In Cerberus’ answer, it claimed there was a material adverse effect because of the “adverse changes in the debt and equity markets.” Nevertheless, the parties reached a settlement agreement on October 19, 2011, which resulted in a decrease of the purchase price by $180 million.

By settling the case, the judiciary– in this instance, the United States Bankruptcy Court for the Southern District of New York – is once again left unable to interpret another MAE provision. Such judicial interpretation is important for elucidating MAEs and clarifying when a buyer can successfully invoke a material adverse effect to walk away from a negotiated agreement. A small number of cases involving the interpretation and application of MAEs have been litigated from start to finish.4 To date, the Delaware courts have never found there to be a material adverse effect in the specific context of a merger agreement.

The question, therefore, is what is a MAE’s true purpose? This is a valid query since, in most cases, invoking a material adverse effect will be futile due to the fact that a court is highly unlikely to find that one has occurred. In a recent survey, Nixon Peabody identified that the use of MAEs in publically filed agreements consisting of asset purchases, stock purchases, and merger agreements, increased from 93% to 96% between June 1, 2010 and May 31, 2011.5

This undoubtedly demonstrates that, post the financial turbulence in 2007-2009, buyers, such as Cerberus and Chatham, are still negotiating for MAEs to use as leverage – in effect, arming themselves with a quasi-mulligan to renegotiate the agreement. Forcing a seller to litigate whether the buyer is entitled to invoke a material adverse effect is extraordinarily costly.

Consider the magnitude of the expense a seller would incur if it were to engage in full-scale discovery to prove the non-existence of a material adverse effect. There would be depositions of integral executives, which would contribute to a lack of productivity and presumably decrease the value of the firm; there would be a battle of highly expensive experts explaining, in their opinion, why or why not a material adverse effect occurred to the target; and there would be an unimaginable amount of documents produced in order to prove or disprove the claim. Therefore, in most cases, the economically prudent firm will simply renegotiate the purchase price to save the headache, expense, and, not to mention, expedite the efficient closing of the transaction so that new strategies can be effectively implemented.

Although Nixon Peabody reports that the current economic environment provides attractive sellers with a lot of leverage in the negotiation of MAEs (which is evidenced by the 23% increase in the use of definitional carve-outs), firms, such as Cerberus and Chatham, are still able to utilize MAEs as leverage to renegotiate deals. It is worthwhile to note that Inkeepers was in Chapter 11 during the negotiations; therefore, it certainly was in a weak position and not an attractive target. The actual MAE was heavily favored toward Cerberus. Nevertheless, the case demonstrates that MAEs continue to be of value to buyers.

A significant portion of the MAE puzzle remains to be filled-in by the courts. As a result, many questions persist: How much longer will targets endure this strategy? Are targets utterly defenseless? Are there any defensive measures that sellers can adopt to counter its inherent vulnerability? If one thing is for certain, however, firms such as Cerberus and Chatham are still negotiating for MAEs and reaping the economic benefits.

1 See, e.g., Weil Briefing: MAC/MAE Provisions. ↵
2 In re Innkeepers USA Trust v. Cerberus Series Four Holdings, Case No. 11-02557. ↵
3 Such as Bain Capital’s acquisition of Home Depot’s wholesale supply unit or KKR and Goldman Sachs termination of the transaction with Harman International and taking it private. ↵
4 IBP, Inc. v. Tyson Foods, Inc. 789 A.2d 14, 54-55 (Del. Ch. 2001) (where the Delaware Chancery Court, applying New York law, stated that MAE clauses are to be construed narrowly against the party invoking the clause); Genesco v. Finish Line, Inc., No. 07-2137-II(III) (Tenn. Ch., Dec. 27, 2007) (where the Tennessee Court of Chancery found that the buyer failed to demonstrate the existence of a MAE because the genesis of the target’s financial deterioration was the result of general economic conditions, which was expressly carved-out); Hexion Specialty Chemical, Inc. v. Huntsman Corp., 965 A.2d 715, 738-739 (Del. Ch. 2008) (where the Delaware Chancery Court stated that the party claiming the material adverse effect bears a heavy burden of proof and emphasized that successfully demonstrating one has occurred is extremely difficult). ↵
5 Nixon Peabody’s 10th Annual “Study of Current Negotiation Trends Involving Material Adverse Change Clauses in M&A Transactions”. ↵

Venture Capital as Targeted Self-Help?

Posted on by Joseph R. Morrison, Jr.

Many believe there are serious issues with the economy and the trajectory of our two concurrent wars. Unfortunately, these two headline concerns come together to affect veterans more profoundly than the average American; the unemployment rate among young veterans (30%) is just short of double that of comparable non-veterans ages 18-24. How do you counteract this phenomenon and harness the power of disciplined young people who have served their country? Venture Capital seems to be part of the answer.

National Public Radio (NPR) had a story on Morning Edition about a Milwaukee, WI based group called VETransfer that is focused on helping veterans start their own businesses. The VETransfer program utilizes a huge (13,000+) network of volunteer experts to help its start-ups with a variety of services including connecting owners with financing and management assistance. The stated goal is “to teach veterans how to become entrepreneurs and assisting them to accelerate veteran owned innovations.” The group has 15,000 sq ft of space for collaboration, meetings, and organization, and a few small businesses that have been incubated by the program have plans to hire other veterans as part of their company expansion plans. One of the initial grants ($3 million) came from the Department of Veterans Affairs, but there are a number of other private sector supporters as well.

This isn’t “venture capital” solving the problem, but it is the ideas behind venture capital that are helping to attack the root of a problem. The military prepares young men and women for productive lives, but right now they seem stranded once they get home. Now, with some assistance from the government in the form of what looks like a block grant, there is some hope for these veterans and the power of the private sector is taking over. The venture model is serving as the self-help mechanism that the nation needs to attack the problem of veteran unemployment, and it is truly a great thing to see. Hopefully we will see more of it.

The website for the article is: http://www.npr.org/2011/10/25/141092122/a-business-incubator-gives-funding-and-jobs-to-vets
The website for the group is: http://vetransfer.org/

Venture Capital Industry Makes Inroads in Non-Traditional Markets

Posted on by Joseph R. Morrison, Jr.

The New York Times DealBook column is a useful source of interesting information. However, this week a few things struck me as particularly intriguing. Apparently the United States Department of Defense (DoD), the $600B+ entity that runs the largest supply chain operation in the world, has discovered the power of venture capital. The Defense Venture Catalyst Initiative is a collaboration between the DoD and venture capitalists that seeks to “utilize private sector Venture Capital (VC) expertise in discovering and evaluating the merits of emerging technology” in order to solve DoD problems. It is a huge vote of confidence for the VC industry, something most Americans are unfamiliar with and unsure of, to have the DoD explicitly acknowledge that venture capitalists have unique and important skills. While the government might not be broadly popular, the Department of Defense is a completely different entity, and I think their vote of confidence will speak to a large sector of the public.

Once the government acknowledges that venture capitalists can contribute meaningfully to the largest public sector agency, there can’t be much left out there, right? (Insert your “the government is the slowest adopter” joke here.) Actually, the NFL announced this week that it is looking to join the venture capital game too. The league, managed by some of the country’s wealthiest and most successful businesspeople, is looking to start its own $30M+ venture capital fund. The owners might even let the Players Union invest alongside its fund. While the NFL owners are looking to be active in the “angel” space rather than the traditional venture capital arena, you would have to think that the MLB, the NHL, and the NBA can’t be far behind the curve here. This, like the DoD involvement, is a positive step for the VC industry as a whole; if there is anything that can help shape a positive view of venture capital with Main Street America, its good old football.

It’s no secret in the financial industry that venture capitalists are skilled entrepreneurs with a keen eye for trends and good investments. However, having two giants like the NFL and the Department of Defense openly acknowledge that the industry offers a unique skill set is a great thing. It is good for the investors, and it’s good for the profile of the Venture Capital industry as a whole.

The Defense Venture Catalyst Initiative website can be found here: http://devenci.dtic.mil/
The NFL investment reference can be found here: http://www.sportsbusinessdaily.com/Journal/Issues/2011/10/17/Leagues-and-Governing-Bodies/NFL-fund.aspx

Emerging Markets Provide Potential Gains and Headaches for Private Equity Firms

Posted on by Mark Franke

Dealbook reported this week that emerging market opportunities are beginning to bear fruit, noting that China boasts three of the largest markets for I.P.O.’s and the fastest growing markets for deals are Ukraine, Thailand, and Chile. Private equity firms like the Carlyle Group and Blackstone have committed significant capital to acquiring stakes in companies abroad and have set up offices in many emerging economic nations to capitalize on the shift of opportunity from the developed world to these untapped frontiers. Wall Street is responding to the sluggish growth at home by turning its eyes abroad, but these opportunities can bring headaches.

Putting aside the administrative costs and barriers to entry of working with foreign governments and in new, sometimes recalcitrant, markets, one major legal problem that arises when an American firm buys stakes in a foreign company is the need to comply with the Foreign Corrupt Practices Act (FCPA). Under this act, a U.S.-based company may not use bribes to “obtain or retain” business.

Private equity funds all offer substantially the same things: capital infusions and management expertise. While name recognition and a good track record may go a long way, the terms of the deals between companies and private equity firms are almost always on substantially similar terms, and the firms exert control over the companies in substantially similar ways—20% cut of the net profits as carried interest upon exit, preferred stock and management control by seeking board placements and various other mechanisms to mitigate downside exposure and maximize upside gains. Why should a company in a foreign jurisdiction respond to a bid from one private equity firm over another? In many cultures, gifts are an expected part of business transactions, and it is a natural impulse to try to grease the wheels of a negotiation. Indeed, a common practice on Wall Street in domestic deals is to do just that. A dinner here, a Broadway show there. Why not? Because the S.E.C. and D.O.J. say you can’t.

There are ways that skilled lawyers could exploit the margins of meaning in the language of the FCPA, contracting the scope of the word “bribe” so as not to capture the activity of their client. But this opportunity would only be meaningful in the context of defending an enforcement action, and private equity firms, like any rational actor, want to avoid litigation. It is risky business to depend on a creative argument from a verbal technician where the act may be questionable. The issue is not whether the act is an actual bribe, but whether the agencies will pursue an enforcement action. The agencies have lawyers too, and those lawyers spend their days scouring filings for suspicious activities and get paid to show how an act fits within the scope of the language. Moreover, beyond litigation costs, who wants to be on the S.E.C’s or D.O.J.’s bad side?

Consequently, when engaging in a deal abroad, especially in nations known for corruption, firms are having to spend more and more on FCPA compliance. While this is good news for law firms (FCPA compliance is a huge cash cow), the robust enforcement of the act is leading to astronomical costs that could arguably be stifling foreign investment. Certainly, American ideals require that firms act with integrity abroad, but with compliance costs going through the roof, at some point firms are likely to accept the cost of being on the bad side of U.S. Government and take the risk of losing a suit. In a world of rational economic actors, the loudest input in a firm’s decision is cost.

In the meantime, however, while costs of either option are comparable, firms will likely choose to comply. There is talk in Washington to make compliance less onerous, but with the election season in full swing, who knows when that will happen.

Michigan & the Smart Money: What the State Needs Today to Build Tomorrow

Posted on by Joseph R. Morrison, Jr.

The smart money has not been flowing into Michigan in a long time. However, that money is starting to come back to Michigan again. This smart money—investments coming from well-informed and experienced financiers —is the key to a recovery for Michigan, and the state government needs to work hard to accelerate that trend. As Michigan shifts away from the auto-dependent economy that has forced the state into a multi-decade decline, the state government needs to focus its effort on attracting the smart money, and it needs to ramp that effort up now.

In order for the state to diversify away from the auto industry, Michigan should make a concerted effort to attract smart money with as much effort as it expends trying to attract tourists. Central to a recovery will be the smart money that helps grow new businesses. Venture capital companies can provide the money and expertise to help young companies get off the ground at a time when traditional funding routes are not open to start-up businesses. Michigan is ripe for continued growth if it focuses on showcasing what it has in spades: a strong university system that spins off opportunities and talent, an abundance of skilled labor, and low barriers to investment. Not only is there room for more money in Michigan but also the demonstrated venture capital returns are impressive enough that the state should be able to sell itself as an attractive investment locale if it makes the effort.3

Michigan’s CEO, Governor Rick Snyder, and its Board, Michigan’s legislature, need to coalesce around this reality; the path to recovery will come if Michigan focuses on attracting the smart money. Quick hits and fun headlines will not help, but venture capital firms like Detroit Venture Partners will. The venture capital investments can help build a solid foundation for a diverse economy, and they can leverage the work already done, such as Governor Granholm’s focus on attracting new industries by encouraging investment in battery and alternative fuel manufacturers. The blitz should ensure that local companies know where to seek the funds. Michigan should also showcase what the state offers to large venture firms around the country. This won’t be a sexy, short-term investment like film tax credits, but it will help create jobs, and it will build a strong foundation for growth and diversification.

Right after Governor Snyder gets home from his trip to Asia, where he will try to drum up trade deals, he needs to have his Chief of Staff put together a domestic itinerary. If Gov. Snyder puts in some hours promoting Michigan in Silicon Valley and New York City, those cities will be promoting Michigan in the not-too-distant future as the next great American turnaround story