Q apitulation

Qualcomm had some big news after the close, announcing that they were enacting a massive corporate restructuring. This included a huge reduction in workforce and other cost-cutting measures, as well as promises to buy back more shares and increase their dividend, and even potentially to split the company in two. They are rotating out three board members and only adding one back, thus shrinking the board. Big changes.  
This is all in response to Jana Partner’s activist campaign against the company launched back in May. Jana actually got to pick the two incoming board members.

This is capitulation with a Capital Q.

And as far as we the public know, Jana did all that with a letter. 

I first wrote about this when Jana launched their campaign, and in that post I said the best way to defend against an activist is to give them most of their demands without actually ceding too much power. Giving away a fifth of your board seats definitely fails that test.

The company also announced some pretty messy results as well. During the conference call, management spent most of their prepared remarks talking about the restructuring rather than the results. They mentioned cost reductions about 137 times by my count in their comments. Going back to my earlier post, they certainly have a lot of things they need to cut. When companies get as big as Qualcomm is, there are always lots of inefficiencies.

So a generous interpretation of today’s news is that the management team realized now would be a good time to  change the culture and fix the cost structure. They have tried before, but now they can use the outside influence as an extra tool to leverage change.

That is the generous interpretation, because it is hard to think of another reason why the company would give in so much, so quickly.

As I mentioned, I think the cost reductions are overdue, but are going to be hard to do in a sensible manner, in the timeframe discussed. And the reduction in non-core businesses makes a lot of sense (MediaFlo, Mirasol….). What troubles me more is that the company appears to be seriously considering splitting in two. For a variety of reasons, I think this is a bad idea. However, the company is now saying they are considering that possibility. Of course, ‘considering’ something does not mean that it will happen, but it sounded like they were actually setting up a special committee of independent board members to make that call.

The whole thing leaves me a bit confused, and I suspect I am not alone. Conceding to activists normally boosts the stock price, but Qualcomm shares are unchanged since Jana went public with their campaign, and were trading basically flat after hours (not the best indicator). On one hand, Qualcomm is doing a bunch of things that will make the stock more attractive – buybacks, margin improvements, etc. On the other, many investors may read the speed with which they gave in as a signal that conditions are worse than outsiders believed. Certainly this quarter’s results did little to alter that outlook.  

My opinion is that the company’s core business engine – chips, technology and licenses – are still intact and strong. The company is just dealing with the fact that mobile growth is slowing with the law of large numbers. When you have Qualcomm’s market share, it is very hard to grow faster than the market. Still, I think it has a solid foundation, so that it just needs to fix its costs. Nothing they said today change my view on that, except for the fact that they are letting Jana push them around. Are things that bad? The title of my last note was “There is Nothing to Fear but Fear Itself” but I suspect that fear may have been enough.

IPO Series Chapter 6 – “The Process”

KEY LESSON: Be prepared. Decisions made before the IPO can have lasting implications long after the IPO.

In this chapter, I am going to use broad strokes to walk through the IPO process. My goal is to tee up the next few chapters which focus on companies making good first impressions with investors. This chapter is NOT a definitive guide by any measure. The lawyers and bankers provide that, and I lack their expertise. Instead, I want to hit a couple high (low?) points of the process, the key decision making points.

The Early Days

Companies typically find themselves meeting bankers long before they even decide to go public. Good bankers are pro-active, seeking out promising companies, or portfolio companies of prominent venture capitalists who they know. This leads many management teams to think they are well prepared for the IPO, having heard about it from bankers for years ahead of the fact. By this point in the series, it should be clear that this is not the case. To put it delicately, bankers may be pre-disposed to highlight the positive aspects of an IPO.

In the next stage, management teams start to prepare for going public. This is not a final decision, but there is a lot of preparation work required. The CFO brings in the auditors and starts getting the accounting systems up to speed, and starts installing a whole new compliance regime. Costly. Not entirely useful, but a requirement. The auditors then start preparing financial reports that look like actual quarterly filings. Similarly, the lawyers start to get more involved around here and begin handling capital markets questions in addition to the regular business issues about which they have already been advising.

As plans for an IPO get more serious, it is time to pick bankers. The bake-off or beauty pageant rolls around. Multiple banks send teams of people in suits. We walked through this in Chapter 5. Soon after, the company picks its bankers, and the real preparation work begins.

Now come the ‘Org Meetings’, in which all of the underwriting syndicate get together with management to get on the same page. Management gives the bankers a deep dive into the company’s operations. The bankers and lawyers search for their respective hot button issues.

This leads to preparation of the S-1 (or Prospectus) and other SEC filings. My sense is that this drafting process is one of the earliest, time-intensive executive interactions with the IPO process. These things can suck up days of non-stop, looked-in-the-conference-room meetings.  So here’s a PRO tip If you have a really good head of marketing, make sure to involve them. For me, the S-1 is one of the hardest corners to turn in the IPO process. Companies can sound so exciting when they are private, but nothing is as sobering as reading an SEC filing.

Go/No-Go

We have now reached the point of no-return. Companies that file to go public and then pull the IPO often have to wait an extra period of time before being able to file again, or suffer some other form of informal punishment that makes the IPO process harder. So once everything is ready, companies need to make a big commitment.

Assuming that decision is a yes, management teams now begin dipping their toe into the water of public markets.

First, the team holds another Org Meeting with all the research analysts. (This used to be held in conjunction with the bankers, but post-1990’s regulations changed that.) Good analysts often know private company management teams ahead of this time, but this will be the company’s financials’ first impression on the research team. I have seen many IPOs die in this room. Management teams can tell they are in trouble when they post their financial projections and are met with silence. When analysts see numbers their natural inclination is to ask questions. But they are under pressure to be respectful to management teams, so when they see something they do not like, they realize it is better to say nothing. This is one of those moments where the bankers and public markets (in the form of analysts) really diverge. Not all companies will make good stocks for investors. Analysts have to justify their investment thesis on all of their stock recommendations a dozen times a day, so they have a decent sense of what will work. At this stage, the unveiling, analysts want to be helpful, but also recognize that there are limits on what the public markets will accept.

This is a key turning point for the IPO process. The whole point of this series is to highlight the importance of setting expectations. Those expectations are born when analysts first see these numbers. Management teams need to present something that is close to what they ultimately want the Street to expect. The next two chapters are dedicated to how to achieve this.

After this, bankers and analysts will ask for other forms of due diligence in the form of outside reference calls with customers and suppliers. These are usually very straightforward, but I mention this now because it is something that may take some time to prepare, better to think of it early.

The Big Day Approaches

After these are done, the company usually has a big To-Do list with items from all constituents that they need to work through. Once these are done, at some point, management teams and their boards make the final call to file publicly.

This is then followed by more To-Do items, often revolving around the SEC’s response to the S-1 document. But now everyone is expecting an eventual IPO.

Once are the legal items are cleared and the underwriters think the company is ready, it is time for the roadshow.

In this, the management team travels the country and sometimes the world in a very short time period. They present an overview of the company and its financials all boiled down to a one-hour PowerPoint deck. (Obviously, preparation of this deck began far earlier.)

For many executives, the IPO roadshow is a once-in-a-career event. It is pretty horrible from a daily life perspective, but also amazing. The road show usually takes eight to fifteen business days. Management teams give the same presentation to as many investors as possible every day. In Boston or New York, where travel times are relatively short, this can mean giving the pitch ten times a day. Motion is constant. Get up. Go to meet investors. Then the next meeting. Then the next. Lunch, if it comes, is out of a box or two mouthfuls over a lunch meeting where there is too much talking to be done. The day ends with either a dinner meeting with a handful of investors or on a plane to the next city. Repeat.

The road show tests stamina and sanity. It is one of those things that is ‘fun’ in hindsight. And remember every one of these meetings count. Investors are forming their first impressions of management team and building models of what they think the stock is worth. A good road show can have a huge impact on a stock’s valuation. So, no pressure.

And remember, during this two or three week process, management teams are having to finalize their financial filings, and, you know, run their business remotely.

At the end of the roadshow, the underwriters all huddle together the night before the IPO and match investor demand to supply of the stock, setting the IPO price. There are all kinds of complexities here, some of which I will touch on in later chapters. But in reality you can pick your metaphor – smoke-filled room, Black Box, inscrutable cult – somehow the price for the IPO is set. (Ask all your underwriters how it works, but ask them separately and compare their answers. )

Management teams typically spend that night in New York so that first thing the next morning, they can ring the bell at the NYSE or push the button at NASDAQ. Then stock starts trading.

That’s it. Time to get back to your day job.

This is Chapter 6 in “A Practical Guide to IPOs”. You can find Chapter 1 here and Chapter 5 here.

Do we really need to regulate trolls? The law of unintended consequences

I am going to range a bit from my usual subject matter here. I have been thinking a little about patents and all the joy around “Intellectual Property” (IP). But be forewarned, this legal analysis is worth the same amount as my non-existent JD.

Let me say upfront that I do not like ‘patent trolls’, or companies that buy up patents and use them to sue other people. And having seen an IP lawsuit up close, I can also attest that the way we organize IP in this country needs some very serious repair.

So, you think I would be all in favor of US House of Representatives Bill #9 (HR9), also known as the U.S. Innovation Act. (And right away, that name should be a warning.) HR 9 has been presented to the public and the media as “patent reform”, a bill which penalizes “trolls” from harming “innovators”.

And here is where we start to get in trouble.

First, defining a ‘troll’ or an ‘inventor’ is very hard. For example, what if a company invented all kinds of things ten years ago, but today lives solely on license revenue from those inventions? Where do you draw the line? The closer you look, the murkier it gets.

Second, it is not entirely clear that we need a new law to defend against ‘trolls’. There were a number of legal decisions last year that hurt some of the bigger IP firms meaningfully. Infamous ‘trolls’ like Intellectual Ventures is still alive, but has cut back its ambitions quite a bit. Do we need another law if the courts have already fixed much of the problem?

Third, does HR9 really fix the problem? As with most things, could it come at a cost? A key provision of HR 9 is that in a lawsuit regarding a patent, the loser pays the winner’s legal bill. These bills can be measured in tens of millions of dollars. Maybe that sounds reasonable, but one of the things that has me concerned is that HR9 ‘pierces the corporate veil’. Modern capitalism is based on the idea of limited liability. If you are an investor in a company, you can not be held personally responsible for the actions of that company. If the company loses a lawsuit, you the investor do not have to chip in to pay for the penalty.  However, HR9 allows for investors in patent-holding entities to be held liable for losses in a lawsuit.

If you really hate trolls, that may sound reasonable, but there are some ‘unexpected’ consequences of that. What if the person losing the lawsuit is not a troll, but a start-up? As I noted above, defining a troll is very tricky. So maybe a broad reading of HR9 means that any start-up that loses an IP lawsuit with a bigger company can be on the hook for massive legal bills.

One of the saddest things in our legal system today is the fact that an IP lawsuit can cost more money than you would need to raise to start a company. Put another way, the legal bill from a lost IP lawsuit can be more than a company raises from its investors. Add to this, the fact that those venture investors can be on the hook for legal fees above and beyond what they invested, and I think it is safe to say that no start-up is ever going to sue a bigger company if HR9 passes. This would seem to effectively invalidate all start-up IP, since no one would be able to afford to defend themselves.

Like I said, I am not a lawyer, I do not know all the intricacies of this, but it certainly seems possible that HR9 could lead to small companies (aka companies that actually innovate) being punished and having their IP rendered defenseless.

It seems like HR9 is one of those things where strong emotion (against trolls) is being channeled in a direction that creates more problems than it solves.

More Wirless Infrastructure

In my post looking at all the good that Microsoft did for Nokia Networks, I touched on a subject that I want to explore further- the wireless infrastructure market. I know in that post I warned that this was one of the dullest subjects in tech, but I could not help myself. Covering that market day to day can be very dull, but viewed from the perspective of a multi-year cycle there are some important things happening.

In the previous note I said:

I find this level of consolidation, in an immensely conservative industry, to be staggering. I would argue we are likely to see another round of consolidation somewhere down the line. But that is a topic for a different post. 

This is that other post.

First, let me define the market. It is the market for base stations and other pieces of network equipment that connect a cell phone to the Internet. This business emerged as vendors of specialty network equipment for mobie operators. Today there are five companies that really dominate the space:

  • Ericsson
  • Huawei
  • Nokia Networks + Alcatel-Lucent
  • Samsung
  • ZTE

Historically, base stations were worth a lot of money, but with price compression the value has shifted to other parts of the chain. Like so many things, the value here is increasingly being found in the software and integration parts of the sale. As a result, the big equipment vendors are in many ways becoming systems integrators that focus on the telecom vertical.

Selling equipment alone is no longer profitable. Base stations for 2G networks used to sell for $500,000, while today you can buy a 4G base station for as low as $10,000. That sounds bad, and it certainly caused big problems for Lucent, Motorola, Nortel and Siemens. But Ericsson barely slowed down. The remaining players in the space have  found other ways to deliver value to their operator customers. This has largely meant switching to sales of software, services and integration. That sounds nebulous, but is really not that different from a consumer paying $600 for a phone that only cost Apple $150 to build.

The ability of the remaing five vendors to adapt to this new value chain varies across a spectrum. Samsung, the smallest, is probably the most reliant on hardware. ZTE and Huawei are more weighted to the hardware end of the scale, but no one should underestimate the advances they are making in moving more towards software and services. Huawei, in particular, has become very active in promoting various open source software communities. This is classical strategy, destsbilize a rival’s competitive advantage by creating replacements.

In fact, another trend shaping the industry is the fact that the network iteslf is changing. Once upon a time we had different kinds of networks – a network for telephone companies, a network for cable companies, a network for academics, a network for governments, and a bunch of networks for businesses. Each of these had their own standards and suppliers. Today, we are pretty much down to two networks – Telecom (and cable) access networks and the Internet. Telecom operators, especially mobile operators, still spend a lot of money building their networks and thus get to design ‘custom’ gear for their industry, but pretty much everyone else uses the same gear.

I do not want to stray into the land of abbreviations, but if I did, here is the point where I would mention SDN and NFV.  Let’s not go down that path. Instead,  I will leave it with we are very likely seeing a move towards a complete compression of network types. It is very possible, that a few years from now, every type of network will run on the same sorts of equipment. The exact shape that takes is still very much up for debate, but the underlying trends are pretty clear.

For the big five telecom suppliers, this likley means that one of their big defensive barriers will disappear, and new entrants will start storming the citadel of operator capex dollars. Maybe those new entrants will be software companies running on commodity hardware, or maybe those new entrants will be named Cisco and HP.  Too soon to tell, but this will be one of the more interesting spectacles to watch in technology over the next decade.

This does not mean that the telecom majors are doomed. But I do think it will prevent them from enjoying any stability. Even the strongest of these companies, Ericsson, has some big holes in its product categories. These holes are big enough that they will likely either have to pay up for some big acquisitions (JNPR? FFIV? BRCD?) or end up being acquired themselves (very, very unlikely).  Nonetheless, Ericsson has the resources and relationships in the industry, it is hard to see them exiting. There is also the possibility that they jump a step ahead of everyone else taking computing in a different direction. They have not been standing still.

By contrast, Samsung looks very small. They have made a lot of progress in recent years, coming out of nowhere. I also think the parent chaebol sees this as a big addressable market for them to partially replace the inevitable decline of their handset business. So they have the motivation and resources to stick with it. Unfortunately, their product line is sub-scale and generally lacking in software. I think they either make a big acquisition bet or eventually fade away.

Huawei and ZTE have significant technical resources to stay in the race. They also have significant… how to put this…Institutional Resources which can back them up. For instance, their ability to get a $10 billion line of credit from China’s State-run banks to help customers finance equipment purchases. I think people tend to lump these companies together too often. They are run very differently, with very different corporate cultures. My sense is that Huawei is much further ahead in building software stacks, while ZTE has a much broader enterprise distribution channel. So maybe they eventually go their separate ways.

That leaves Nokia Networks (+ Siemens + Alcatel + Lucent), the company which sparked this series. If you line up all of the combined companies’ products, my guess is that you would find there are still some significant gaps in their line up. Importantly, Alcatel-Lucent does have some very interesting networking software initiatives. But right there is the problem – how do we line up the combined companies products? The deal probably does not close for another year, and then the real work begins. What gets cut? What gets fully funded? Integrating companies is complex and can be painful. Adding to the problem is the fact that Alcatel itself probably never fully digested Lucent. The Lucent acqusistion carried all kinds of baggage with it. My guess is that they are still working out accounting and compliance questions from ten years ago.  The combined company is going to look unstable for a number of years. So even though I celebrated their survival in my last post, I have to wonder how much longer they will remain independent.

Microsoft’s Loss is Networking’s Gain

This morning, Microsoft announced that it was shutting down what was left of Nokia. There has been a ton written today about the strategic, personal, historical and branding implications of all this for the handset industry. But I think everyone is missing a key part of the story, a silver lining of sorts. In the process of burning through $7.6 billion of shareholders’ money, Microsoft helped save the US and European wireless networking industry.

Many people forget that Nokia still exists. The consumer brand is now dead (or in deep hibernation), but the network infrastructure side of the company still exists as Nokia Networks. And Nokia Networks is doing pretty well. They got $7.2 billion from Microsoft for their handset business and then turned around and bought Alcatel-Lucent one of their bigger competitors.

A bit of history is in order. Ten years ago, the wireless infrastructure business hit hard times. The build-out for 3G networks had been largely completed, so there were no easy sources of revenue growth left. At the same time, the Chinese networking companies were starting to emerge on the scene. In 2005, Huawei and ZTE were not well known outside of China, but in the ensuing years they became giants. And in the early years of that transformation they sparked a massive wave of price compression, just as volume growth dried up at the end of 3G build-out.

This was the end of the Glory Days for the cellular infrastructure companies. They had been reeling since the dot.com bubble burst in 2001, but the demand for 3G networks had kept things going for a while. At this stage there were nine vendors of 3G base station systems:

  • Alcatel
  • Ericsson
  • Huawei
  • Lucent
  • Nokia
  • Motorola
  • Nortel
  • Siemens
  • ZTE

Then, things began to change.

The first to fall was the American giant Lucent. April, 2006 Alcatel announced they would acquire them. In June, Nokia began a joint venture with Siemens, which effectively marked Siemens exit from wireless infrastructure. In January of 2009 Nortel declared bankruptcy, and by July had sold their cellular assets to Ericsson. In 2010, Nokia Siemens acquired Motorola’s base station business, and then in July 2013, Nokia bought out Siemens stake in their JV. In April of 2014, Nokia sold their handset business to Microsoft. And just this April, Nokia Networks announced that they plan to acquire Alcatel-Lucent

In nine years, we have gone from nine vendors down to five:

  • Ericsson
  • Huawei
  • Nokia Networks
  • Samsung
  • ZTE

The only newcomer to the list is Samsung. They have been selling networking gear all along, but this year they have reached sufficient size that I think they should be included on the list of global players.

I find this level of consolidation, in an immensely conservative industry, to be staggering.  I would argue that even this number is not stable, and we will likely see another round of consolidation somewhere down the line. But that is a topic for a different post.

Returning to Nokia. If you had asked me two years ago what I thought would happen to Nokia Networks, I would have never guessed that they would end up as one of the last remaining vendors in this space. My guess was that they would have sold off multiple businesses and shrunk to a much smaller entity. For the better part of a decade, they were the sub-scale vendor, lacking Ericsson’s or Huawei’s market power. Instead, Microsoft overpaid them for the handset business. Like winning the lottery, Nokia Networks got a new lease on life. Someone there should seriously send Steve Ballmer a really nice fruit basket.

With the winnings from their handset sale, Nokia Networks became the consolidator. Next time you hear someone complain that software companies are sucking up all the profits from the hardware industry, remember to raise a glass to Microsoft for sharing some of the wealth back the other direction.

Wireless Infrastructure Timeline

  • Alcatel announces acquisition of Lucent, April 2006
  • Nokia forms JV with Siemens, June 19, 2006
  • Nortel declares bankruptcy, January 14, 2009
  • Ericsson announces acquisition of Nortel’s mobile infrastructure assets, July 25, 2009
  • Motorola sells networking business to Nokia Siemens, July 19, 2010
  • Nokia buys out Siemens share of JV,  July 1, 2103
  • Microsoft acquires Nokia Handsets, April 25, 1014
  • Nokia acquires Alcatel-Lucent, April 15, 2015
  • Microsoft shuts down Nokia, July 8, 2015

Post-script

I have been meaning to write about wireless infrastructure since Mobile World Congress. I touched on the subject briefly then, including a mention of Samsung’s small but growing weight. However, I did not really do the deep dive I intended. In part because writing about wireless infrastructure is the second most boring thing to do in tech blogging. (The first most boring, of course, is reading about wireless infrastructure.) This industry moves glacially. The wireless operators have to be very conservative and very bureaucratic, and their big vendors take that cue.

Another reason that I did not write more on the subject is that I did not feel that I had enough to say about Nokia Networks at the time. I actually went to their analyst briefing. It was held in a far-away conference room late on the Sunday night prior to the show. I had just arrived early that morning and was feeling the effects of jet lag. I made it through the opening remarks, and then Nokia’s CEO got on stage. Ten minutes in he said that he was going to tell us about a very exciting industry. Wow. That piqued my interest. He then put up a slide of a mountain stream. That exciting industry was “Water”.

You will forgive me for deciding that there were better ways for me to spend a Sunday evening in Barcelona, and I made for the exits.

In all seriousness,the wireless infrastructure business is getting interesting again, because networking is changing. This business moves in very slow technology cycles, but a new wave is approaching. And, surprisingly, it looks like Nokia could be a big part of that change.

IPO Series Chapter #5 – How to Pick Your Bankers

KEY LESSON: Pick your underwriters based on their research analysts and equity salespeople, not their relationship banker
I first had the idea for this series after breakfast several years ago. I was meeting with a friend, who is a venture investor. We spent most of the time talking about the joys of raising kids in San Francisco. But at some point, he mentioned that one of his portfolio companies was getting ready to go public. The Board had met with a half dozen bankers as part of their ‘beauty pageant’.

“They all said the same things, with the same slides in their pitch decks. How,” he asked, “do we tell them apart?”

A one hour breakfast, became a three hour brunch, as I unloaded all my thoughts on the subject. Given that this series is set to approach 20,000 words, it should be clear that I have a lot of thoughts on the subject. And these thoughts are based on years of experience with some not-so-pretty IPOs.

At the end of that brunch, he finally admitted that they had already picked their lead underwriter, and had picked it solely based of the name brand of that bank. Needless to say, I do not think that is the best strategy.

To go public in the US typically requires hiring a syndicate of investment banks to underwrite the IPO. (There are other options, but I do not recommend them.) The underwriters have a huge impact on the fate of an IPO, and parts of them play a role in the company long after the IPO. So choosing bankers is very important for management teams.

As with all things around going public, there are two very different sides to consider – the IPO process itself and then life as a public company. These two sides correspond to two very separate sides of an investment bank. As with much of the IPO, once the big day happens, many of the banking participants move on to their next project. Yet typically, those are the people on which companies spend most of their focus.

The pattern here is pretty commonplace. Bankers come in to pitch their services. Boards usually organize ‘beauty pageants’ or ‘bake-offs’, bringing in a half dozen banks to present on one day. The banks send two types of bankers – the relationship bankers who know the company and have been calling on them for years; and the execution bankers who specialize in executing IPOs. The relationship banker will demonstrate loyalty and familiarity with the company, ‘establishing trust’ is how a hostage negotiator would describe it. Then the execution banker talks about how many IPOs they have done, their distribution capacity – establishing their seriousness. Both of these are important, and companies should base 50% of their decision on what they think about these two banking teams.

The trouble starts with the other 50% of the decision. Banking pitches all focus on one element that should be ignored, and ignore one that should be the focus.

The part that should be ignored is the estimated IPO valuation included in every pitch (these are often communicated verbally and not put on paper). There is a strong temptation to see this estimate as a ‘bid’, and to pick bankers based on this number. Resist that temptation. The actual valuation is almost certainly going to be very different by the time the IPO actually happens. Moreover, the distinction between a bank that says a company’s value is $1 billion and one that says it is worth $1.1 billion is meaningless. The banks are not going to determine the company’s value. The ‘Market’ will determine that. This estimate does not shed any light on the merits of one bank versus another.

What matters far more to the process are the research analysts and sales team that each bank has. For obscure regulatory reasons, banks are prohibited from saying much (if anything) about their analysts in IPO pitch decks. This is a crucial piece for companies to consider, and it is glossed over in these key presentations.

Before choosing IPO bankers, companies must meet with the analyst who would cover them as well as a representative from the banks’ sales team. The analyst will shape the way in which a company is presented to investors, and the sales team will provide a megaphone to make sure that every investor hears that story. Company management really wants to know the quality of these people.

Companies should gauge if analysts:

  • Understand the company’s industry and demonstrate a knowledge of the constituents of that industry.
  • Have familiarity with the company, ideally having visited in the past.
  • Maintains a good reputation with investors, and has credibility to talk about a new story.

Companies should gauge if equity sales teams:

  • Have national relationships with big investors, or focus on particular regions or types of funds
  • Sales teams do not need to know the industry or the company, but need to be able to learn the basics quickly
  • Have a good relationship with the bankers
  • Have a good relationship with the analysts

It just takes a few questions to fully gauge this, but companies have to make sure they get the chance to ask these questions directly to analysts and salespeople.

Finally, companies typically need a number of underwriters. For IPOs under $1 billion (plus or minus), companies can usually get by with five or six underwriters. At the other end of the spectrum, Alibaba’s $22 billion IPO had over 20 underwriters. Companies need to choose one bank to be the lead underwriter, and then fill out the team based on the size of the deal and each bank’s strengths. Typically, this means two mega banks (aka bulge bracket firms) and then three of four smaller banks. Management teams should spend some time thinking about the smaller banks. The lead underwriter is a big role and tends to get most of the team and Board’s attention. But the small firms will end up playing an important role well after the IPO.

And this is one of the key points. During the IPO roadshow, these underwriters deploy a small army of employees to promote the stock. Then, after the IPO most of the bankers will fade away, but all of the analysts will stick around and become part of managements’ routines. Management teams will probably never see the banks’ salespeople again, but those salespeople will absolutely remember how the company performed on the roadshow, and they will hold those memories for a long time.

This is a lot of people to keep track of, so it is easy to lose sight of which ones matter. I am not denigrating the work of bankers, but management teams need to keep track of the long-term, and that can get lost in the midst of this whole process.

The Shape of Bubbles – Ripples Beneath the Surface

I have become fixated, if not quite obsessed, with thinking about what will happen when the venture spigot gets shut off. I having been writing a lot about this (and here). There is a lot of uncertainty out there on this subject, but I have boiled it down to three things about which I am fairly certain:

  1. At some point, it will become much harder to raise a venture fund and thus much harder to get funded by a venture investor.
  2. This is normal. The rest of Capitalism calls it a business cycle, and it does not have to end with a “Bursting Bubble”, or a post-cataclysmic landscape.
  3. It is very hard to predict who will suffer most in the downturn. There are lots of interdependencies which means that problems in one area can cause much bigger problems in another.

Beyond these, it is all open to debate.

I have been going back and forth on this subject with a few people lately. And there has been a growing chatter in the venture community on this subject, largely spurred by Benedict Evans’ piece (my response here). Fred Wilson at Union Square Ventures had an interesting post on the subject as well. His views are very similar to mine – capital flows matter. In fact that was one of the first posts on this site.

Of course, the fact that post is over three years old should make it clear that predicting the timing of downturns is impossible.

Nonetheless, I think it is worth exploring more, to prepare for that inevitable downturn. The world of finance has been grappling with this subject for a long time. (Some would say the whole basis for finance is the preparation for downturns.) And a key concept in managing for risk is the idea of diversification aka not putting all eggs in one basket. For instance, do not put all retirement assets in one stock, because any number of random events could wipe out that company. Better to buy multiple stocks (or a mutual fund), and better still to buy stocks and bonds and real estate etc.

At its heart, this is the idea behind a venture capital fund – lots of companies in the fund may go bust, but no single disaster can wipe out the fund, giving time for the other companies to find their inner unicorn.

For companies, however, diversification is much harder. We do not like to invest in companies that do too many things – they lose focus.

So it seems to me that understanding the risk landscape for the Someday Downturn is to understand where companies are exposed to risk. I tend to think of this as being ‘levered’ to something. Start-ups are levered bets on some form of technology. They are betting big on a particular outcome.

Of course, there are all kinds of risks out there. So the question is determining which risks will be exposed when venture funding becomes harder. Evans argues that companies today are much less dependent on venture funding because they are more capital efficient and thus much closer to breakeven. I think it depends on what the company is trying to achieve.

Take Uber as an example. They have raised a lot of money, but if the venture spigot turns off tomorrow, they already have a massive business. And it is geographically hedged – meaning that even if the Bay Area economy tanks their business in other parts of the world will likely not be affected. By contrast, there are a lot of developer-focused companies out there: dev tools, ad networks, etc. When it becomes hard for app developers to raise venture money, they will cut back on all of these things.

I think this area will be one of the big victims of Rule #3 from above – the Law of Unexpected Consequences. For instance, one of the more interesting areas today is ‘Big Data’. There are a lot of really interesting companies out there building Big Data applications, platforms and analytics. However, dig a little deeper, and it quickly becomes clear that the biggest consumers of big datasets, and thus Big Data tools, are ad networks. We could easily see some very promising Big Data companies disappear because they are much more levered to these sorts of vulnerable sub-sectors.

There are also businesses which do not scale in a linear fashion. For instance, enterprise software companies need to build up a large sales force, find reference customers and close very complex deals. These companies need to go a couple years wholly dependent on venture funding in order to reach critical mass. Admittedly, conditions are much easier today than they were even five years ago. There is a lot more flexibility in enterprise software adoption patterns. Nonetheless, it should be clear that losing venture funding is going to be harder for some types of companies than others.

Let me conclude by repeating that I do not want to come across as alarmist. I have no idea when the business cycle will turn. And it is clear that many parts of the industry will be able to escape unscathed. Nonetheless, I will stand by my statements above. Things will change. It may or may not be a catastrophe. But there will be a lot of unexpected casualties along the way.

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