Archive for April, 2016

Analysts are going gaga for Facebook’s earnings beat

mark zuckerberg facebook happy smiling virtual reality oculusFrank Zauritz – Pool /Getty ImagesFacebook CEO Mark Zuckerberg.
Facebook-A $118.84


Facebook smashed it.

The social-network giant beat expectations when it reported its first-quarter earnings on Wednesday, sending stock soaring in after-hours trading by 8% to an all-time high. The growth comes off the back of the company’s strong mobile business.

CEO Mark Zuckerberg is also proposing a new share structure that will allow him to give away the majority of his fortune to charity while retaining voting control of the company.

Analysts are responding uniformly positive to the news, raising their price targets for the company as they reiterate overweight/buy ratings across the board.

We’ve rounded up a selection of reactions from analysts — but first, here are the key numbers, via Business Insider’s Jillian D’Onfro:

  • Earnings per share: $0.77 versus $0.62 expected.
  • Revenue: $5.38 billion versus $5.25 billion expected, up 52% year-over-year. Ad revenue is up 57% year-over-year.
  • Monthly active users: 1.65 billion versus 1.62 billion expected.
  • Daily active users: 1.09 billion on average for March. This quarter, 66% of Facebook’s monthly active users were daily active users, which is up from 65% during the same period last year.
  • Total costs and expenses were $3.37 billion, up 29% year-over-year, and capital expenditures were $1.13 billion.
  • Free cash flow for the first quarter of 2016 was $1.85 billion.
  • Facebook has 13,600 employees, up 35% from the same time last year.
  • Most of Facebook’s revenue comes from North America and Europe, with only about 24% ($1.3 billion) coming from Asia-Pacific and the rest of the world. But those areas account for 66% of its monthly active users. The average revenue per user in those regions is still tiny, compared to in the US: $1.56 and $0.91, respectively, versus $12.43 and $3.98 in the US and Europe.

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Above the Crowd

On the Road to Recap:

Why the Unicorn Financing Market Just Became Dangerous…For All Involved

In February of last year, Fortune magazine writers Erin Griffith and Dan Primack declared 2015 “The Age of the Unicorns” noting — “Fortune counts more than 80 startups that have been valued at $1 billion or more by venture capitalists.” By January of 2016, that number had ballooned to 229. One key to this population growth has been the remarkable ease of the Unicorn fundraising process: Pick a new valuation well above your last one, put together a presentation deck, solicit offers, and watch the hundreds of million of dollars flow into your bank account. Twelve to eighteen months later, you hit the road and do it again — super simple.

While not obvious on the surface, there has been a fundamental sea-change in the investment community that has made the incremental Unicorn investment a substantially more dangerous and complicated practice. All Unicorn participants — founders, company employees, venture investors and their limited partners (LPs) — are seeing their fortunes put at risk from the very nature of the Unicorn phenomenon itself. The pressures of lofty paper valuations, massive burn rates (and the subsequent need for more cash), and unprecedented low levels of IPOs and M&A, have created a complex and unique circumstance that many Unicorn CEOs and investors are ill-prepared to navigate.

Many have noted that the aggregate shareholder value created by all of the Unicorns will vastly overshadow the losses from the inevitable failed unicorns. This likely truism is driven by the clear success of this generation’s transformational companies (AirBNB, Slack, Snapchat, Uber, etc). While this could provide some sense of comfort, most are not exposed to a Unicorn basket, and there is no index you can buy. Rather, most participants in the ecosystem have exposure to and responsibility for specific company performance, which is exactly why the changing landscape is important to understand.

Perhaps the seminal bubble-popping event was John Carreyrou’s October 16th investigative analysis of Theranos in the Wall Street Journal. John was the first to uncover that just because a company can raise money from a handful of investors at a very high price, it does not guarantee (i) everything is going well at the company, or (ii) those shares are permanently worth the last round valuation. Ironically, Carreyou is not a Silicon Valley-focused reporter, and the success of the piece served as a wake-up call for other journalists who may have been struck by Unicorn fever. Next came Rolfe Winkler’s deep dive “Highly Valued Startup Zenefits Runs Into Turbulence.” We should expect more of these in the future.

In late 2015, many public technology companies saw a significant retrenchment in their share prices primarily as a result of a reduction in valuation multiples. A high performing, high-growth SAAS company that may have been worth 10 or more times revenue was suddenly worth 4-7 times revenue. The same thing happened to many Internet stocks. These broad-based multiple contractions have an immediate impact on what investors are willing to pay for the more mature private companies.

Late 2015 also brought the arrival of “mutual fund markdowns.” Many Unicorns had taken private fundraising dollars from mutual funds. These mutual funds “mark-to-market” every day, and fund managers are compensated periodically on this performance. As a result, most firms have independent internal groups that periodically analyze valuations. With the public markets down, these groups began writing down Unicorn valuations. Once more, the fantasy began to come apart. The last round is not the permanent price, and being private does not mean you get a free pass on scrutiny.

At the same time, we also started to see an increase in startup failure. In addition to high profile companies like Fab.com, Quirky, Homejoy, and Secret, numerous other VC-backed companies began to shut their doors. There were in fact so many that CB Insights started a list. Layoffs have also become more prevalent. Mixpanel, Jawbone, Twitter, HotelTonight and many others made the tough decision to reduce headcount in an attempt to lower expenses (and presumably burn rate). Many modern entrepreneurs have limited exposure to the notion of failure or layoffs because it has been so long since these things were common in the industry.

By the first quarter of 2016, the late-stage financing market had changed materially. Investors were becoming nervous and were no longer willing to underwrite new Unicorn-level financings at the drop of a hat. Moreover, once high-flying startups began to struggle on the fundraising trail. In Silicon Valley boardrooms, where “growth at all costs” had been the mantra for many years, people began to imagine a world where the cost of capital could rise dramatically, and profits could come back in vogue. Anxiety slowly crept into everyone’s world.

About this same point in time, the journalists that focus specifically on the venture capital industry noted something quite profound. In 1999, record valuations coexisted with record IPOs and shareholder liquidity. 2015 was the exact opposite. Record private Unicorn valuations were offset by increasingly fewer and fewer IPOs. If 1999 was a wet (read liquid) bubble, 2015 was a particularly dry one. Everyone was successful on paper, but in terms of real cash-on-cash returns, there was little to show. In Q1 of 2016 there were zero VC-backed technology IPOs. Less than one year since declaring it the “Age of the Unicorns,” Fortune Magazine was back with a dire warning, “Silicon Valley’s $585 Billion Problem: Good Luck Getting Out.

As we move forward, it is important for all players in the ecosystem to realize that the game has changed. Equally important, each player must understand how the new rules apply to them specifically. We will start by highlighting several emotional biases that can irrationally impact everyone’s decision making process. Next we will highlight the new player in the ecosystem that is poised to take advantage of these aforementioned changes and emerging biases. Lastly, we will then walk through each player in the ecosystem and what they should consider as they navigate this brave new world.

Emotional Biases

When academicians study markets, one common assumption is that the market participants will act in a rational way. But what if the participants are in a position that leads them to non-optimal and potentially irrational behavior? Many biases bring irrationality to the Unicorn fundraising environment:

  1. Founder/CEO — Many Unicorn founders and CEOs have never experienced a difficult fundraising environment — they have only known success. Also, they have a strong belief that any sign of weakness (such as a down round) will have a catastrophic impact on their culture, hiring process, and ability to retain employees. Their own ego is also a factor – will a down round signal weakness?  It might be hard to imagine the level of fear and anxiety that can creep into a formerly confident mind in a transitional moment like this.
  2. Investors — The typical 2016 VC investor is also subject to emotional bias. They are likely sitting on amazing paper-based gains that have already been recorded as a success by their own investors — the LPs. Anything that hints of a down round brings questions about the success metrics that have already been “booked.” Furthermore, an abundance of such write-downs could impede their ability to raise their next fund. So an anxious investor might have multiple incentives to protect appearances — to do anything they can to prevent a down round.
  3. Anyone that has already “banked” their return — Whether you are a founder, executive, seed investor, VC, or late stage investor, there is a chance that you have taken the last round valuation and multiplied it by your ownership position and told yourself that you are worth this amount. It is simple human nature that if you have done this mental exercise and convinced yourself of a foregone conclusion, you will have difficulty rationalizing a down round investment.
  4. A race for the exits — As fear of downward price movement takes hold, some players in the ecosystem will attempt a brisk and desperate grab at immediate liquidity, placing their own interests at the front of the line. This happens in every market transition, and can create quite a bit of tension between the different constituents in each company. We have already seen examples of founders and management obtaining liquidity in front of investors. And there are also modern examples of investors beating the founders and employees out the door. Obviously, simultaneous liquidity is the most appropriate choice, however, fear of price deterioration as well as lengthened liquidity timing can cause parties on both sides to take a “me first” perspective.

The Sharks Arrive With Dirty Term Sheets

Who are the Sharks?  These are sophisticated and opportunistic investors that instinctively understand the aforementioned biases of the participants and know exactly how to craft investments that can exploit the situation. They lie in wait of these exact situations, and salivate at the opportunity to exercise their advantage.

“Dirty” or structured term sheets are proposed investments where the majority of the economic gains for the investor come not from the headline valuation, but rather through a series of dirty terms that are hidden deeper in the document. This allows the Shark to meet the valuation “ask” of the entrepreneur and VC board member, all the while knowing that they will make excellent returns, even at exits that are far below the cover valuation.

Examples of dirty terms include guaranteed IPO returns, ratchets, PIK Dividends, series-based M&A vetoes, and superior preferences or liquidity rights. The typical Silicon Valley term sheet does not include such terms. The reason these terms can produce returns by themselves is that they set the stage for a rejiggering of the capitalization table at some point in the future. This is why the founder and their VC BOD member can still hold onto the illusion that everything is fine. The adjustment does not happen now, it will happen later.

Dirty term sheets are a massive problem for two reasons. One is that they “unpack” or “explode” at some point in the future. You can no longer simply look at the cap table and estimate your return. Once you have accepted a dirty offering, the payout at each potential future valuation requires a complex analysis, where the return for the Shark is calculated first, and then the remains are shared by everyone else. The second reason they are a massive problem is that their complexity will render future financings all but impossible.

Any investor asked to follow a dirty offering will look at the complexity of the previous offering and likely opt out. This severely heightens the risk of either running out of money or a complete recapitalization that wipes out previous shareholders (founder, employees, and investors alike). So, while it may seem innocuous to take such a round, and while it will solve your short term emotional biases and concerns, you may be putting your whole company in a much riskier position without even knowing it.

Some later-stage investors may be tempted to become Sharks themselves and start including structured terms into their own term sheets. Following through and succeeding at such a strategy will require these investors to truly embrace being a Shark. They will need to be comfortable knowing that they are adverse to and in conflict with the founders, employees, and other investors on the capitalization chart. And they will need to be content knowing that they can win while others lose. This is not for the faint of heart, and certainly is not consistent with the typical investor behavior of the past several years.

Let us now take a deeper dive into what this new fundraising environment means for each participant in the ecosystem.


Today’s Unicorn entrepreneur has been trained in an environment that may look radically different from what lies ahead. Here is the historic perspective. Money has been easy to raise. The market favors growth over profits. Competition also has access to capital. So, raise as much as you can as fast as you can, and be super-ambitious. Take as much market share as you can.

Never in the history of venture capital have early stage startups had access to so much capital. Back in 1999, if a company raised $30mm before an IPO, that was considered a large historic raise. Today, private companies have raised 10x that amount and more. And consequently, the burn rates are 10x larger than they were back then. All of which creates a voraciously hungry Unicorn. One that needs lots and lots of capital (if it is to stay on the current trajectory).

For the first time, perhaps in their lives, these entrepreneurs may face a situation where they cannot raise a clean incremental financing at a flat to up round. This is uncharted territory. There are a few alternatives:

  1. The first option available to many Unicorns today is a dirty term sheet. As discussed above, these terms can cleverly fool the inexperienced operator, because they are able to “meet the ask” with respect to cover valuation, and the accepting founder does not realize the carnage that will come down the road. The only reason one would accept such a deal is to maintain valuation appearances that simply do not matter. Taking a terms-laden deal is like starting the clock on a time bomb. Your only option is to hit the IPO window as fast as possible (Note: Box and Square were able to thread this needle successfully), otherwise, the terms will eat you alive. The main problem is that you will never raise another private round again, as no new investor will want to live on top of the termy round. So you will be stuck negotiating with the lender that already proved they were smarter than you.
  2. Take a clean round at a lower valuation. This will seem like a massive failure to many modern entrepreneurs, but they should quickly adjust their thinking. Reed Hastings at Netflix raised money in a high profile down round as a public CEO. Every single public CEO has had days where the stock price falls — it is common and accepted. The only thing you are protecting is image and ego and in the long run they absolutely do not matter. You should be more concerned about the long-term valuation of your shares, and minimizing the chance that you have the whole thing taken away from you. Terms are the true Godzilla that should scare you to death. A down round is nothing. Get over it and move on. Option #2 is way better than option #1.
  3. Buckle down and do whatever it takes to get cash-flow positive with your current cash balance. This might be the most foreign of all the choices, as your board of directors has been advising you to do the exact opposite for the past four years. You have been told to be “bold” and “ambitious” and that there is no better time to grab market share. Despite this, the only way to be completely in control of your own destiny is to remove the need for incremental capital raises altogether. Achieving profitability is the most liberating action a startup can accomplish. Now you make your own decisions. It will also minimize future dilution. Gavin Baker, a high-profile portfolio manager at Fidelity has a message for Unicorn CEOs: “Generate $1 of free cash flow, and then you can invest everything else in growth and stay at $1 in free cash flow for years.  I get that you want to grow and I want you to grow, but let’s internally finance that growth by spending gross margin dollars rather than new dilutive dollars of equity.  Ultimately, internally financing growth is the only way to control your own destiny rather than being at the mercy of the capital markets.”
  4. Go public. In the long run, the very best way for founders to look after their own ownership as well as that of their employees is to IPO. Until an IPO, common shares sit behind preferred shares. Most preferred shares have different types of control functions and most of them have a senior preference over common. If you really want to liberate your own common shares and those of your employees, then you want to convert the preferred to common and remove both the control and the liquidation preference over your shares. Many founders have been erroneously advised that IPOs are bad things and that the way to success is to “stay private longer.” Not only is an IPO better for your company (see Mark Zuckerberg and Marc Benioff on this subject), but an IPO is the best way to ensure the long-term value of your (and your employees’) shares.

It is worth noting that stock prices go up and stock prices go down. There is not a single high-profile public company that has been able to avoid time periods where their shares underperformed. Amazon went from $106 to $6 as a public company. Salesforce went from $16 to $6 and stayed below $10 for many months. Netflix went from $38 to $8 in six months. Remember Facebook’s first six months as a public company?

If you cannot handle a down valuation you should seriously consider abandoning the CEO position. Being a great leader means leading in good times as well as tough times. Taking a dirty deal is jeopardizing the future of your company, solely because you are afraid to lead through difficult news.


The explicit details of the capital structure of a company are typically obfuscated from the average employee. You know you work for a Unicorn, and you know you have some common shares. You might also know what percentage you own. And unfortunately, you may assume that the product of your Unicorn valuation and your percentage ownership is what you are worth. Of course, for that to be true, you need to reach a liquidity event (IPO or M&A) at or above the last round valuation with no incremental dilution from new rounds. But guess what: M&A is scarce (no large company wants to pay these prices or absorb these burn rates), and many founders have been told IPOs are bad. So how will you ever get liquid?

For the most part, employees are in the exact same position as founders (above), with the exception that they don’t participate in the decision tree outlined above in 1-4. That said, they should be asking the exact same questions of management:  Can we get to break-even on the money we have?  Do we need to raise more money?  If so, ca we do it on clean terms (vs. dirty)?  Employees should want to know if the founder/CEO would/did take a dirty deal, because common is at the most risk in such a situation. And then you should want to know if your leader is anti-IPO. If your CEO/founder will take a dirty round, and is also anti-IPO the chance that you will ever see liquidity for you shares anywhere near what you think they are worth is very, very low. You should probably move on to another company.


Disclosure: It should be noted that the author of the article and his investment firm reside in this category.

For the most part, early investors in Unicorns are in the same position as founders and employees. This is because these companies have raised so much capital that the early investor is no longer a substantial portion of the voting rights or the liquidation preference stack. As a result, most of their interests are aligned with the common, and key decisions about return and liquidity are the same as for the founder. This investor will also be wary of the dirty term sheet which has the ability to wrestle away control of the entire company. This investor will also have sufficient angst about the difference between paper return and real return, and the lack of overall liquidity in the market. Or at least they should.

The one exception to this is the late-stage investor or the deep-pocketed investor who may represent a substantial part of the overall money raised. This particular type of investor may have protected their ownership through the use of active pro-rata or super pro-rata investing. They may have even encouraged the aggressive “spend-to-win” mentality knowing that they can keep writing checks. They have been acting like a loose-aggressive player at a poker table.

There are two forces which have began to slow down this type of investor. First, as failure has begun to arrive on the scene, these investors have suffered some really big write-offs. These spectacular losses result in a lack of confidence not only for the investor, but more importantly for their LPs. The second problem is that for many of these investors, a single holding can become too large relative to the overall fund. They basically cannot afford to expose themselves to any more risk in a particular name. They use euphemisms to describe having over-eaten such as “fully allocated” or “at capacity.”

This form of big investor indigestion has created a really bizarre and unprecedented activity in the Unicorn world. High-profile investors, who are already armed with plenty of capital, have resorted to hitting the phone banks to solicit others to pile in behind them in their names. The voracious Unicorns need even more capital than these big-boys can afford. Ironically, if you look at the big historic wins of this investor class, there is no record of sending out Evites to other investors. But now they “need” others, which should signal risk to all parties involved. More on this later.

Investors also have to worry about raising their next fund, which can lead to unusual behavior that is independent of each individual company’s situation.  Do you support the dirty term sheet because this allows you to keep your paper-mark and not spook your investors?  Even though you know this may be bad for the company in the long run?  Do you feel the need to raise more capital quickly before the prices erode further and bring down your IRR? Do you feel the need to have more money to keep feeding the cash hungry companies you have already funded?


LPs are the large pools of capital, such as endowments and foundations, that invest in VC firms, hedge funds and the like. They are the real capital that make the system work. LPs evaluate the performance of the different investors in the ecosystem and make decisions about whether to fund their next effort or not. It’s a difficult job because the feedback cycles are so long — especially when it comes to investing in illiquid assets like startups (and Unicorns).

Another big challenge for LPs is that they are asked to measure the performance of these illiquid assets even though doing so is quite difficult and may not be indicative of future real cash returns. In this case, many LPs have incorporated the high performance of Unicorn valuations into their overall results which has created very strong performance gains for the venture capital category. In a sense they have already “banked” the gains. The problem obviously is that the lack of any material liquidity in the market combined with the recent correction creates a risk that they may not see the actual cash returns for the paper gains they already booked.

Furthermore, as mentioned earlier, they may face increased solicitation from VC firms who want to accelerate their fundraising process in the middle of this highly anxious environment. A recent WSJ article, “Venture-Capital Firms Draw a Rush of New Money,” highlights that VC firms are raising new funds from LPs at the highest rate in 15 years, even though cash liquidity is sitting at a seven-year low. A few sentences from the article are worth republishing here:

  • In recent years venture firms have written bigger checks and encouraged companies to spend to battle for market supremacy.  That left some venture firms short of cash, requiring them to raise money sooner than in years past to continue reaping fees and making new investments.
  • Some venture capitalists say the fundraising spike is timed to ensure that paper gains on startup investments still look attractive.
  • Cash distributions are what matter at the end of the day, but big paper gains still make for good fundraising pitches.

In addition to these issues, there has also been an increase in “inside rounds” where investors write new checks into companies where they are already investors, avoiding the “market check” that might have resulted in a potentially down valuation. This activity, which has an obvious conflict of interest, makes the LP’s job of judging VC performance even more difficult.

Against this difficult backdrop, many firms are asking their LPs to make new accelerated commitments to their next fund, exactly when evaluation is most difficult and anxiety may be at a cyclical peak. Moreover, deep down most LPs know that performance in the VC sector is counter cyclical to the amount of money raised by VCs. If you over-fund the industry, aggregate returns fall. Writing huge checks to bloated multibillion dollar VC funds could easily exacerbate the problems that already exist.

One response from the LP community might be to demand commitments from new funds that prohibit inside-led rounds and cross-fund investing. This can help to ensure that new capital is not put to use in an attempt to save previous investment decisions — an activity known as “throwing good money after bad.”

If this were not enough, some LPs are also being solicited to participate in SPVs (Special Purpose Vehicles), frequently from the very funds they have backed. As discussed earlier, some investors have reached a stage when they are overcommitted to a particular company in a particular fund (“at capacity”). Yet these investors want to keep providing capital to their Unicorns and support a growth-over-profits attitude. So they create a one-time special purpose investment vehicle (while greedily asking for even more carry). And the SPV has the added risk that is has no portfolio diversification or “look-back” feature to provide downside protection.

Obviously the LPs can just say “no” to participating in the SPV (even though they may feel the pressure of obligation from the fund). This is likely the smart move. First, someone is asking you to write a check at the exact time everyone else is overcommitted.  Hey, come help us out, we are drowning over here!  Second, you already have ample exposure to this exact company, through your original investment. Lastly, it is quite unlikely that a historical study of peak-cycle SPV participation shows good returns.


If you have a large pool of money and you haven’t been approached to invest in a Unicorn, it’s simply because people do not know where to find you. There are three types of people who are likely now approaching you, all of whom you should engage with quite carefully:

  1. SPV promoters – As mentioned in the section on LPs, investors have also broadened their SPV marketing more broadly to family offices and other pools of capital. The pitches typically involve phrases such as “you are invited to” or “we will provide access to” an opportunity to invest. This “you are so lucky to have this opportunity” pitch is eerily Madoffian. And remember, this solicitation is coming from investors who actually have money, but already know they are overcommitted.
  2. Brokers and 3rd-tier investment banks promoting the sale of secondary shares in Unicorn companies – If you ask any large family office, they will tell you they are being bombarded with calls and emails offering secondary positions in Unicorn companies. Often with teasers such as “20-40% discount to last round price.”
  3. Incremental Unicorn round – You might also be called on simply to pump more capital into a standard Unicorn round. With many investors “at capacity” due to the historic amounts of capital already raised, some companies are looking under any and every rock they can for more dollars.

One of the shocking realities that is present in many of these “investment opportunities” is a relative absence of pertinent financial information. One would think that these opportunities which are often sold as “pre-IPO” rounds would have something close to the data you might see in an S-1. But often, the financial information is quite limited. And when it is included, it may be presented in a way that is inconsistent with GAAP standards. As an example, most Unicorn CEOs still have no idea that discounts, coupons, and subsidies are contra-revenue.

If an audit is included, it might have massive “qualifications” where the auditor lists all the reasons that this particular audit may not comply with GAAP standards and that things could change materially if they dig in deeper. Investors need to really open their eyes to the fact that these are not IPOs. The companies have not been scrubbed in the same way, and the numbers they are looking at on a PowerPoint deck are potentially erroneous. Here is a recommendation: If you are about to write a multimillion dollar check for an incremental Unicorn investment, ask to speak to the auditor. Find out exactly how much scrutiny has been applied.

New potential investors might also be surprised how few Unicorn executives truly understand their core unit economics. One easy way to spot these pretenders is that they obsessively focus on high level “gross merchandise value” or “multi-year forward bookings” and try to talk past things like true net revenue, gross margin, or operating profitability. They will even claim to be “unit profitable” when all they have really done is stopped being gross margin negative. These companies will one day need real earnings and real profits, and if the company does not proactively address this, you should not be giving them millions of dollars in late stage financings.

Perhaps the biggest mistake untapped investors will make is assuming that because there are branded investors already in the company, that the new investment opportunity must be of high quality. They use the reputation of the other investors as a proxy for due diligence. There are multiple problems with this shortcut. First, these investors are “pot committed.” They invested a long time ago, and without your money their investment is “at risk.” Second, as discussed, they are already full and nervous. They didn’t call you before when they built their reputation.  Why are they friendly now?

The main message for investors who are just now being approached is the following: it’s not the second inning or even the sixth, it’s the fourteenth inning in a five-hour baseball game. You are not being invited to a special dance, you are being approached because you are the lender of last resort. And because of how we meandered to this place in time, parting with your dollars now would be an extremely risky move. Caveat emptor.

SEC Visits Silicon Valley

A few weeks ago, on March 31, 2016, the Chair of the SEC made a trip to Silicon Valley and gave a speech at an event at Stanford Law School. For those that are participating in Unicorn investing or for those considering investing in Unicorns, it would be a good idea to read the entirety of her presentation (which can be found here). Bloomberg’s interpretation of her presentation was that “Silicon Valley Needs To Corral Its Unicorns.

Chair White seems quite aware of the issues and pressures that have an ability to distort the Unicorn fundraising process:

Nearly all venture valuations are highly subjective.  But, one must wonder whether the publicity and pressure to achieve the unicorn benchmark is analogous to that felt by public companies to meet projections they make to the market with the attendant risk of financial reporting problems.

And then she sends a message to all former and future investors regarding the need for increased due diligence:

As I will discuss, the risk of distortion and inaccuracy is amplified because start-up companies, even quite mature ones, often have far less robust internal controls and governance procedures than most public companies.  Vigilance by private companies about the accuracy of their financial results and other disclosures is thus especially critical.

It would be quite unfortunate if the fundraising behavior of the Unicorn herd led to increased SEC involvement and rules with respect to private venture-backed startups. But if those involved believe that “not being public” also means “not being responsible,” we will quickly find ourselves in that exact place. We will have deservedly invited more scrutiny.

Mo Money Mo Problems

Perhaps the biggest lapse in judgment for all of those involved is the assumption that if we can just raise “one more round” everything will be fine. Founders have come to believe that more money is better, and the fluidity of the recent funding environment has led many to believe that heroic fundraising is a competitive advantage. Ironically, the exact opposite is true. The very best entrepreneurs are relatively advantaged in times of scarce capital. They can raise money in any environment. Loose capital allows the less qualified to participate in each market. This less qualified player brings more reckless execution which drags even the best entrepreneur onto an especially sloppy playing field. This threatens returns for all involved.

The reason we are all in this mess is because of the excessive amounts of capital that have poured into the VC-backed startup market. This glut of capital has led to (1) record high burn rates, likely 5-10x those of the 1999 timeframe, (2) most companies operating far, far away from profitability, (3) excessively intense competition driven by access to said capital, (4) delayed or non-existent liquidity for employees and investors, and (5) the aforementioned solicitous fundraising practices. More money will not solve any of these problems — it will only contribute to them. The healthiest thing that could possibly happen is a dramatic increase in the real cost of capital and a return to an appreciation for sound business execution.

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Further to Gerbsman Partners previous e-mail sales letter of March 8, 2016, regarding the sale of certain assets of Palmaz Scientific, I am providing an update on the timing for finalizing the”Bidding Process & Procedures” that need to be approved by the United States Bankruptcy Court for the Western District of Texas, San Antonio Division

Gerbsman Partners has been retained by Palmaz Scientific, Inc. to solicit interest for the acquisition of all, or substantially all, the assets of Palmaz Scientific, Inc.

Headquartered in San Antonio, Texas, with Operations based in Fremont, California, Palmaz Scientific is a medical device company founded in 2008 with disruptive technology platform which will likely change the medical device industry by creating unique way of designing and developing medical implants.

Palmaz Scientific has raised two rounds of private equity financing to date totaling more than $40 million. Palmaz Scientific owes approximately $20 million to creditors, including approximately $12 to senior secured creditors.

On March 4, 2016, Palmaz Scientific, Inc. filed a voluntary petition under Chapter 11 of the United States Bankruptcy Code in the United States Bankruptcy Court for the Western District of Texas, San Antonio Division. Palmaz Scientific intends to sell all or substantially all of its assets pursuant to 11 U.S.C. § 363. As part of that process, Palmaz Scientific intends to seek bankruptcy court approval for bidding and sale procedures related to the auction and sale of its assets. Palmaz Scientific anticipates having a stalking horse bidder in place shortly. It is anticipated that the bankruptcy court will approve bid procedures that will require a bidder to submit a cash deposit of $250,000 and otherwise qualify to bid by submitting financial information confirming such bidder’s ability to close on any sale. When the bankruptcy court has approved the bidding procedures, potential bidders will be provided a copy of same. In the interim potential bidders will only be able to access Palmaz Scientific’s data room by executing the non-disclosure agreement provided to each bidder by Gerbsman Partners.

On April 19, 2016, the United States Bankruptcy Court for the Western District of Texas, San Antonio Division held a hearing and approved an order granting “interim financing” to the Debtor through May 5, 2016. Debtors advised the Court that the proposed “stalking horse” bidder is in a dialog/negotiations with various creditor and investor groups concerning a consensual path forward with the objective of finalizing a “stalking horse” bid, and bid procedures and a possible plan of reorganization for review by the Debtors’ and Creditors Committee Counsel. Once this is finalized it is anticipated the Court will set a date to approve bid procedures, a “stalking horse” bid and asset purchase agreement, allowing for immediate distribution to potential interested parties.

Currently, potential interested parties who have signed an NDA will be able to perform due diligence and have access to the Debtor’s key personnel/intellectual capital, due diligence room and intellectual property lawyer.

Attached, please see a detail check list of information in the Palmaz Scientific due diligence room and a list of key personnel/intellectual capital.

I will update all potential interested parties during the first week of May on the current status and timing of projected approval of the “bidding process/procedures” that must be approved by the United States Bankruptcy Court for the Western District of Texas, San Antonio Division.

Ken Hardesty, Dennis Sholl and I are available to facilitate a continued due diligence and deal status dialog.

Best regards and thank you for your continued interest in the Palmaz Scientific Assets and Intellectual Property.
Steven R. Gerbsman
Gerbsman Partners

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DAVID ROSENBERG: Janet Yellen’s use of one word tells us something has gone wrong

David RosenbergScreenshot via Bloomberg TVDavid Rosenberg

In a truly seminal speech on March 29th, Janet Yellen used the title, The Outlook, Uncertainty, and Monetary Policy.

I have been in this business for 30 years and have never seen a central bank chief slip the word “uncertainty” into the headline.

Not just that, but she invoked the term no fewer than 10 times to describe the domestic and global macro and market backdrop — this even as we pass seven years since the worst point of the Great Recession and seven years into the most radical easing of monetary policy in recorded history.

It begs the question: what has gone wrong?

Well, the obvious answer is that monetary policy simply is a weak antidote to the fundamental and structural impediments to global growth.

The world is still grappling with a problem of over-indebtedness. This is particularly acute in China as the country simultaneously rebalances from overinvestment in the industrial sector to consumer services.

Germany is following a policy of austerity to the detriment of its Eurozone allies (in part due to trust issues with its partners or possibly just a pervasive culture of frugality) -— running a budget surplus, and a current account surplus-to-GDP ratio of over 8% (Germany has now had current account surpluses for 15 years in a row).

So yes, there are lingering debt and competitive hurdles in the way of European growth, but Germany’s refusal to share its economic engine with its neighbors has been a hindrance to say the least.

In Japan, Abenomics has hit a wall as the country continues to weave in and out of a recession with consumer spending and incomes stagnant. The experiment with negative interest rates has failed so far, highlighted by the firming yen and the renewed stranglehold placed on the country’s export sector.

The Brexit vote on June 23rd is a classic fork in the road for the European Union, and the 64% vote (non-binding) in the Netherlands against the treaty with Ukraine (for greater economic ties) underscores the contempt that many in the region have towards the union. All the more so with the refugee and terrorism files, partly the product of open (porous more like it) borders.

Spain’s coalition government is about to fall. Italy’s banks are in disarray. Prime Minister Hollande has backed down on French reforms. Greece is at risk of defaulting again this summer.

Greece riot protestReuters/Alexandros AvramidisA Greek farmer (R) hits a riot police officer with a Greek flag during a demonstration against planned pension reforms in the northern city of Thessaloniki, Greece.

So it is clear the European Union is splintering.

That said, the soft global background only goes so far in explaining why the U.S. economy has been on such soft ground this cycle.

After all, nearly 90% of U.S. GDP is autonomous. The U.S. economy does not reside on an island, that is true, but the global economy really is a two-bit player — a truly decimal place impact.

Where it matters is whether global market anxiety leads to an undesired tightening in domestic financial conditions or if the U.S. dollar rises too far too fast. To be sure, both of these have been in play at different times since last summer, but over time, U.S. growth is much more a local story.

The big story is how the U.S. has shot itself in the foot many times over.

While Obamacare may have been good social policy, it froze the small business sector two years after the detonation of the housing sector and capital markets. One shock layered on top of another.

Fiscal policy was never loosened enough and the move to tighten it so dramatically in 2013 via spending restraint and broad-based tax hikes has exerted dampening economic effects to this day. The structural component of the deficit, once as high as 7%, is now close to zero, as revenue growth (the tax take) is exceeding program spending growth currently by a three to one ratio.

Meanwhile, the Republican who shut down the government four years ago is now in second spot in the GOP primaries, and the leader has become the poster boy for the anti-free-trade movement.

Ted CruzAP Photo/Mike GrollTed Cruz

The tax code has not undergone a face-lift in three decades. We have a White House now making it up as it goes along when it comes to merger activity, adding to business uncertainty over tax and regulatory policy —which is running at historically high levels.

So we have supply side sclerosis in the country, where the lack of budget policy clarity has led to a freeze-up in capital spending and a record-low pace of growth in the private sector capital stock. This in turn has impaired productivity growth, as Janet Yellen herself warned repeatedly before she took over the helm.

Sadly, this is more the domain of fiscal policy than monetary policy. Here we are, more than a year later, with no movement on the fiscal front, and a productivity performance that has gone from bad to worse.

We have endured an erosion in the growth of the capital stock that is impairing productivity. The other input to the production process, labor, is also seeing ever-present constraints.

Because of birth and fertility rates that have gone in reverse, coupled with a decline in immigration (to an extent that would most assuredly bring a smile to The Donald’s face), we have a situation where the growth in the working-age population has slowed to a mere 0.5% annual rate, less than half of what was typical in the past.

In contrast to the old boomer-led cycles of the 1970s, ‘80s and ‘90s, female participation rates are no longer rising, and the rapid growth in two-income families that helped juice up the spending power of cycles gone by, is long over.

So much of the comparatively sluggish growth this cycle is purely demographic.

Then we have a slate of socio-economic factors, many of which have scars from the Great Recession.

Employment among males aged 20 to 24 has not increased in eight years and the employment rate for this group is extremely depressed even if off the bottom. Ditto for those aged 25 to 34.

guy reading on a couch booksp.v/FlickrGuy on the couch.

As for those fertility rates, what woman wants to date, let alone marry, a guy who’s still living with mom and dad? Indeed, an unheard-of 35% of males aged between 18 and 34 live at home.

Part of the problem, a big part, is the dramatic surge in student debt, now equivalent to $100,000 per college grad, and seven years into the recovery, the delinquency rate sits at 8%. So kiss your FICO score goodbye and kiss your ability to secure a mortgage goodbye, too — and so say hello to a massive reversal in the U.S. homeownership rate which is in such steep descent that it is starting to look more and more European.

On top of that, the household sector, at the margin, continues to focus on repairing balance sheets as opposed to embarking on a spending binge, even with incomes picking up recently and the de facto tax windfall from sharply lower gas prices.

Debt-to-income and debt-to-asset ratios are still receding and savings rates trending higher as the typical boomer hitting 60 looks at the life expectancy tables and sees he or she has 25 years left on earth and the dread realization sets in that they haven’t come close to preparing financially for the not-so-golden years that lie ahead.

There is this other little matter called income inequality, which has become a global issue and indeed part of the discourse during this primary season. Always good to see a revolt being conducted peacefully and within the political process (good thing Maximilien Robespierre isn’t around).

But this anti-establishment feel to the primaries, whether it is in the Trump or Sanders camp, certainly does resonate. This feeling of being left out or left behind.

U.S. Republican presidential candidate Donald Trump speaks at a campaign event in an airplane hanger in Rome, New York April 12, 2016. REUTERS/Carlo AllegriThomson ReutersU.S. Republican presidential candidate Donald Trump speaks at a campaign event in an airplane hanger in Rome, New York

I mean, there is nothing wrong with building wealth, but remember that democracy and capitalism are always dancing with each other on a pin.

You don’t want to have too many trailing behind because history shows us time after time that this triggers discontent among the masses, instability and inevitably, upheaval.

The Gini coefficient— a measure of income dispersion — has risen to unprecedented levels.

This by no means suggests that folks at the lower income echelons aren’t better off than they were 10, 20 or 30 years ago, but it means their share of the national income pie is getting smaller, and if you don’t think people, by their nature, aren’t constantly looking over their shoulder, then go and take a Psychology 101 course at your nearest university or community college.

It wouldn’t be so bad if the “middle class” wasn’t disappearing, because what its depletion has done is polarize society — which is why the rancor is so loud during this pre-election circus otherwise known as the U.S. primary season.

The near eradication of the middle class has coincided with a multi-year decline in the labor share of national income, and only very recently has this started to carve out a bottom and hook up (a clear reason why profit margins have started to roll over).

Of course, even as the spoils now are diverted more towards the personal sector, the implications for GDP growth which is all about “spending” are unclear given the uptrend in the savings rate.

A rising savings rate amidst lingering high excess capacity in a global basis means that deflationary pressures are not going to go away.

Central banks will be forced to offset these pressures by ongoing monetary accommodation, though as we are seeing with quantitative easing and negative rates in the euro area and Japan, central banks are losing their effectiveness.

So all this means lower for a lot longer — low growth, low inflation, and low interest rates — from an investment strategy standpoint, it is all about “Safety & Income at a Reasonable Price”, all over again.

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San Francisco, April, 2016
The Advantages of a “Date-Certain M&A Process” over an “Assignment for the Benefit of Creditors – ABC”
Apart from a formal bankruptcy (Chapter 7 or Chapter 11) there are two basic approaches to maximizing enterprise value for under-performing and/or under-capitalized technology, life science, medical device and solar companies and their Intellectual Property: a “Date-Certain M&A Process” and an assignment for the benefit of creditors (ABC).

Both of these processes have significant advantages over a formal bankruptcy in terms of speed, cost and flexibility. Gerbsman Partners’ experience in utilizing a “Date Certain M&A Process” has resulted in numerous transactions that have maximized value anywhere from 2-4 times what a normal M&A process would have generated for distressed asset(s). With a “Date-Certain M&A Process”, the company’s Board of Directors hires a crisis management/ private investment banking firm (“advisor”) to wind down business operations in an orderly fashion and maximize value of the IP and tangible assets.

The advisor works with the board and corporate management to:

  1.  Focus on the control, preservation and forecasting of CASH.
  2. Develop a strategy/action plan and presentation to maximize value of the assets. Including drafting sales materials, preparing information due diligence war-room, assembling a list of all possible interested buyers for the IP and assets of the company and identifying and retaining key employees on a go-forward basis.
  3. Stabilize and provide leadership, motivation and morale to all employees.
  4. Communicate with the Board of Directors, senior management, senior lender, creditors, vendors and all stakeholders in interest.
  5. The company’s attorney prepares very simple “as is, where is” asset-sale documents. (“as is, where is- no reps or warranties” agreements is very important as the Board of Directors, Officers and Investors typically do not want any additional exposure on the deal).
  6. The advisor then contacts and follows-up systematically with all potentially interested parties (to include customers, competitors, strategic partners, vendors and a proprietary distribution list of equity investors) and coordinates their interactions with company personnel, including arranging on-site visits.

Typical terms for a “Date Certain M&A” asset sale include no representations and warranties, a sales date typically three to five weeks from the point that sale materials are ready for distribution (based on available CASH), a significant cash deposit in the $150,000 plus range to bid and a strong preference for cash consideration and the ability to close the deal in 7 business days. Date Certain M&A terms can be varied to suit needs unique to a given situation or corporation. For example, the Board of Directors may choose not to accept any bid or to allow parties to re-bid if there are multiple competitive bids and/or to accept an early bid.

The typical workflow timeline, from hiring an advisor to transaction close and receipt of consideration is four to six weeks, although such timing may be extended if circumstances warrant. Once the consideration is received, the restructuring/insolvency attorney then distributes the consideration to creditors and shareholders (if there is sufficient consideration to satisfy creditors) and takes all necessary steps to wind down the remaining corporate shell, typically with the CFO, including issuing W-2 and 1099 forms, filing final tax returns, shutting down a 401K program and dissolving the corporation etc.

The advantages of a “Date Certain M&A” approach include the following:

Speed – The entire process for a “Date Certain M&A Process” can be concluded in 4 to 6 weeks. Creditors and investors receive their money quickly. The negative public relations impact on investors and board members of a drawn-out process is eliminated. If circumstances require, this timeline can be reduced to as little as two weeks, although a highly abbreviated response time will often impact the final value received during the asset auction.

Reduced Cash Requirements – Given the Date Certain M&A Process compressed turnaround time, there is a significantly reduced requirement for investors to provide cash to support the company during such a process.

Value Maximized – A company in wind-down mode is a rapidly depreciating asset, with management, technical team, customer and creditor relations increasingly strained by fear, uncertainty and doubt. A quick process minimizes this strain and preserves enterprise value. In addition, the fact that an auction will occur on a specified date usually brings all truly interested and qualified parties to the table and quickly flushes out the tire-kickers. In our experience, this process tends to maximize the final value received.

Cost – Advisor fees consist of a retainer plus an agreed percentage of the sale proceeds. Legal fees are also minimized by the extremely simple deal terms. Fees, therefore, do not consume the entire value received for corporate assets.

Control – At all times, the Board of Directors retains complete control over the process. For example, the board of directors can modify the auction terms or even discontinue the auction at any point, thus preserving all options for as long as possible.

Public Relations – As the sale process is private, there is no public disclosure. Once closed, the transaction can be portrayed as a sale of the company with all sales terms kept confidential. Thus, for investors, the company can be listed in their portfolio as sold, not as having gone out of business.

Clean Exit – As the sale process is private, there is no public disclosure. Once closed, the transaction can be portrayed as a sale of the company with all sales terms kept confidential. Thus, for investors, the company can be listed in their portfolio as sold, not as having gone out of business.

To this end the insolvency counsel then takes the lead on all orderly shutdown items.
In an Assignment for the Benefit of Creditors (ABC):

In an assignment for the benefit of creditors (ABC), the company (assignor) enters into a contract whereby it transfers all rights, titles, interests, custody and control of all assets to an independent third-party trustee (assignee). The Assignee acts as a fiduciary for the creditors by liquidating all assets and then distributing the proceeds to the creditors. We feel that an ABC is most appropriate in a situation with one or more highly contentious creditors, as it tends to insulate a board of directors from the process. Nevertheless, we have found that most creditors are rational and will support a quick process designed to maximize the value that they receive. A good advisor will manage relationships with creditors and can often successfully convince them that a non-ABC process is more to their advantage. Apart from its one advantage of insulating the board of directors from the process, an ABC has a number of significant disadvantages, including:

  1. Longer Time to Cash – Creditors and investors will not receive proceeds for at least 7 months (more quickly than in a bankruptcy but far slower than with a “date-certain” auction).
  2. Higher Cost – Ultimately, ABCs tend to be more expensive than a date-certain© auction. It is not uncommon for the entire value received from the sale of company assets to be consumed by fees and/or a transaction for maximizing value may not be consummated in a timely fashion.
  3. Loss of Control – Once the assets are assigned to the independent third-party trustee, the board of directors has no further control over the process. It cannot modify the process in any way or discontinue the process. Thus, it is not possible to explore multiple options in parallel.
  4. Higher Public Relations Profile – The longer time frame for the ABC process and the more formal (and public) legal nature of an ABC make it more difficult to put a positive spin on the final outcome.
  5. Messy Exit – Most independent third-party trustees do not perform the services of cleanly shutting down the remaining corporate shell. Thus, investors must either pay another party to do this job or leave it undone, resulting in increased liability.

About Gerbsman Partners

Gerbsman Partners focuses on maximizing enterprise value for stakeholders and shareholders in under-performing, under-capitalized and under-valued companies and their Intellectual Property. Since 2001, Gerbsman Partners has been involved in maximizing value for 91 technology, medical device, life science, cyber security, digital marketing and solar companies and their Intellectual Property and has restructured/terminated over $810 million of real estate executory contracts and equipment lease/sub-debt obligations. Since inception, Gerbsman Partners has been involved in over $2.3 billion of financings, restructurings and M&A transactions.

Gerbsman Partners has offices and strategic alliances in San Francisco, New York, Virginia/Washington DC, Boston, Europe and Israel.
Gerbsman Partners
Phone: +1.415.456.0628, Cell +1.415.505.4991
Email: Steve@GerbsmanPartners.com
Web: www.gerbsmanpartners.com
BLOG of Intellectual Capital: http://blog.gerbsmanpartners.com

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