Technofile Europe

Death, taxes and financial regulation

As the global banking sector convulses with the most comprehensive restructuring in memory, voices on both sides of the Atlantic are calling for tighter banking regulation in order to prevent a future meltdown.  Heads had to roll and a number of senior executives have lost their jobs, while others find themselves inadvertently turned into civil servants operating state-owned banks. 

Relatively speaking, that was the easy part.  The question now is: how to regulate the industry better without stifling financial innovation?

There is no shortage of ideas coming from European and US regulators, many bad (executive pay caps, short sale bans), some good (clearinghouses for private financial contracts).  The only thing we can say for certain is that there will be amendments to existing Basel II and Mifid regulations, as well as new initiatives to increase disclosure and fiddle with capital adequacy rules.

As a participant on the margins of financial markets, I hope regulators err on the side of improving the transparency and liquidity of existing financial innovations, rather than try to constrain the complex financial products whose reckless distribution got us into this mess.  

The fact is that every link in the chain of this financial crisis -- subprime mortgages, credit default swaps, counterparty defaults, off-balance sheet investment vehicles -- was beset by the same fundamental problem:

insufficient information to
(a) gauge value, and
(b) understand dependencies.

This was an information crisis.  The new financial instruments and their markets simply got ahead of risk managers', CEOs' and regulators' ability to keep track of them.  And this is in spite of all the technical tools to manage this information being readily available.

We have a vested interest in this problem, through our investment in FRSglobal.  Until this year, FRS provided necessary but unexciting solutions to banks to calculate risk and to automate regulatory reporting.  Today, FRS is talking to regulators all over the world about how to improve everyone's visibility of risks and interdependencies among banks.  FRS CEO Steve Husk blogs about these issues here. 

The crisis is the catalyst that is finally bringing together risk management, business analytics and reporting -- a 3-way marriage software vendors and consultants have talked about for a decade, but which no one has yet consummated.  It's time for CFOs to have a single view of risk exposure, and to report on that view to both their boards and the regulators. 

To this end, FRS has made two acquisitions in the past 3 months: Swiss-based vendor of integrated risk management solutions IRIS (see Gartner's take here), and SAP/Business Objects subsidiary SECAM+, a specialist in regulatory reporting for the UK securities industry. 

Traditional ERP and even banking systems vendors acknowledge that the new paradigm of risk management and reporting is a highly specialised activity, requiring purpose-built analytical tools and extensive banking domain knowledge.  For this reason, incumbents like SAP and Temenos are partnering with FRS to deliver unified risk management to their clients.

It's only the beginning of the consolidation in this market and a lot of uncertainty remains.  But to death and taxes, we can undoubtedly add 'more regulation' to the list of certainties.

Survival Kit for Growth Companies in 12.5 Steps

We’ve seen a lot of advice flying around on how to prepare for a recession, but most of it is targeted either at large companies or at VC-backed businesses (eg, the now-notorious Sequoia presentation). 

But most companies are neither.  They are the thousands of growth companies that are profitable or close to it, and who are used to growing faster than their markets in any part of the cycle.  For them, weathering the downturn is about striking the right balance -– planning for survival without sacrificing the growth opportunity.

Below is a summary of the 12 1/2 steps I'm working through with my portfolio companies and entrepreneurs I meet.  It's based on our experience with past recessions and taking into account the particulars of this downturn.  As always, your comments are welcome.

Your New Budget

1. Write a revenue budget for 2009 that aims for modest growth (20% if you’re used to 50%, 15% if 40%, etc), and a cost budget for 0% growth.  This won’t be enough (see below), but it’s a start.

2. Cut personnel costs.  Cut deep enough to remain cash-flow positive even if 2009 growth is anemic.  If revenue growth turns out to be higher, you can start recruiting again mid-year and you’ll benefit from a better pool of candidates.

Caveat: Cutting deeply the first time you do it is the best way to preserve leadership credibility.  Making multiple successive cuts destroys confidence in management and leads to departures of good employees.  Many of you will have made one cut already, which wasn’t deep enough, so try to make the second the last, and say so.

3. Freeze general & administrative expenses, then go through them with a fine-tooth comb and cut some more.  You can always travel less (or less comfortably), use Skype,  postpone seminars, push back on lawyers’ fees, etc.  This is is mostly symbolic if you’re already quite lean, but it puts everyone in cost-conscious mode, which is critical.

4. Cut discretionary marketing spend and re-focus on online lead generation and performance-based advertising – anything that drives immediate sales.  Your brand will survive 6 months out of the limelight of TV ads.  The hard part is working out which marketing activity to cut –- knowing your conversion metrics by channel is key.

5. Review variable pay schemes to make sure they are both realistic for the low-growth scenario AND still incentivise growth.  You should still aim to outgrow your broader market, even in a downturn.  Your best people need to be incentivised to achieve this.

However: Avoid an across-the-board reduction in executive pay.  You may think this has powerful symbolic value in front of employees fearful of losing their jobs, but it makes resignations inevitable in an unpredictable way.  Better to reduce aggregate executive pay by letting a few execs go and giving the remainder bigger jobs –- which can be highly motivating.

Business Strategy

6. Analyse the profitability of your business by product, by customer, and by business line.  Eliminate those that are not contributing positively to your central overheads; consider eliminating the least profitable 10-20%.  There is no room for marginal clients (but you all have them!).

Important: Continue investing in activities that improve your efficiency or increase sales, whether it’s technology development to automate the backoffice, or consultants that increase your sales productivity.

7. Pause or stop skunk works and other experiments with new product ideas or business lines.  You can always revisit these later.  Consider parking that expansion plan for China for a couple of quarters.

8. Reposition your product/service offering.  Every pitch to your customers needs to be about saving them money, about solving their problems  caused by the recession.  Quantify the quick ROI.  If you’re very sure of your ability to deliver cash value to clients, consider risk-sharing contracts where some of your fees are variable.

9. Increase your share of markets where your competition is weakest.  Many companies will disappear in the coming year; try to predict which ones and focus on those territories or segments.

10. Focus, focus, focus – this is the time to be doubly ruthless in getting management to prioritise the projects and tasks that affect the business in the short to medium term.

Cash Management

11. Manage cash collection tightly.  Your clients will stretch payments and your suppliers will push you hard to collect early.  You have no choice but to do the same to them.

12. Look for creative financing options to improve your working capital: sale & leaseback of equipment or property, receivables financing, government grants, bank financing (to the extent available).

The Human Factor

12.5 Most important, talk openly and honestly to your managers and your employees!  The most damaging effect we see in recessions is a demoralising split between senior management in crisis mode, and everyone else wondering what they’re up to.  Well-run companies can pull through if everyone is motivated to do it, and if management appears to be in control.  It is the CEO’s role to listen and to lead, in good times and bad.

Time for risk management 2.0

The unrelenting waves of bad news coming out of the financial services industry these days all seem to wash ashore at the same place -- on the desk of the CFO and his compliance team.  Financial risk management just isn't what it used to be.  Or rather, the risks themselves have moved so significantly in the past 10 years that banks have not managed to keep up (except, perhaps, the whiz kids at Goldman). 

Time for a change, or as Steve Husk of FRSGlobal suggests in his new blog, banks need to decide whether they want to be Southampton FC or Real Madrid (really!).  It's time for a two-dot-oh look at risk management.

In my view 3 main factors have contributed to an exponential increase in the scope and complexity of risk.  First came an acceleration of innovation in financial instruments, with investment banks churning out weekly new spins on the securitisation concept to ensure they had something to sell to clients, something to trade in and out of to generate fees, and -- in many cases -- something for their prop trading desks to buy.  The sophistication of these products have come a long way from Bowie bonds to a finely-graded slice of sub-prime mortgage risk.

Second, the entrance of new market participants, including hedge funds, corporate treasurers and commodities offices, the banks' own SIVs, and -- finally -- consumers egged on by retail bank 'consultants', created greater liquidity but also volatility in the market.  The behaviour of many of these market participants was not predictable and their reaction in a crisis untested.

Third, capital moves at higher speed through many more jurisdictions today than ever before.  There is no such thing as a domestic or European or American capital market today.  The effects of US subprime mortgage defaults are being felt in every corner of the globe, much to the surprise, no doubt, of the poor souls who are actually defaulting.

And yet the risk management approach used by most banks is based on legislative concepts that were  developed decades ago, in a simpler world of capital offsetting measurable liabilities on balance sheets (Basel I, Basel II).  The IT systems on which these risk management processes run tend to be local financial accounting systems, perhaps even instrument- or business line- specific, with little integration with the global exposures of the bank.

Now that banks know their real exposure is much greater than previously thought, and with the threat of increasing regulation if they don't find a way to regulate themselves, it's time to dust off those formerly Utopian plans to develop a single view of risk within the bank.

For both banks and corporates the era of keeping multiple sets of books is drawing to a close.  There is simply too much risk in not having a single, accurate, reportable view of the financial position.  The board will want to see the same report as the regulator is reviewing.  And when the regulator calls, the CFO wants to make sure his reporting is fully transparent and auditable.

It's no longer good enough to delegate local regulatory reporting to country managers. Regulators from different countries are talking to each other and are likely to exchange information and continue to harmonise their requirements.  For a bank operating across the world, this means local financial reporting needs to be in synch.  For the CFO, it means reducing risk of local error, while increasing global visibility of the numbers. 

So while general IT spending by banks will likely tail off this year, spending on compliance processes and risk management will continue, benefting firms like Riskmetrics (which is going public today), Algorithmics, and FRSGlobal (disclosure: Kennet company).  It is likely to take banks years to consolidate their financial systems and arrive at a single, global view of risk and an ability to report on it.  The good news is that this is more a process problem than a technology problem.  Recent technical innovations, including all that Web 2.0 stuff, make it notionally easier than ever.  Time to get started.

House of Commons v. Private Equity: first round

I missed yesterday's broadcast of the UK parliamentary committee excoriating questioning senior private equity executives from KKR, Permira, 3i and Carlyle, but I did get a few second-hand reports today.  For the detail, you can still watch it on the Parliament site here, PEHub provides a summary here, and the Financial Times gave it front page treatment today.  For more hysterical coverage, turn to the Daily Mail here...

I'll come to my views on the controversy in a moment, but first: what is with this process??  Neither the parliamentarians nor the private equity bigwigs were properly briefed for this debate, leading to a tetchy stalemate that made both sides look bad.  The MPs have a legitimate cause to investigate the industry, but surely owe it to their constituents (and their target) to be moderately informed about it. 

But it was clear from their questions that most did not understand the basic structure of private equity funds or how they earn fees and share in the success of their investments.  And it is surely sad that their questions became personal and appeared to be driven more by envy of the super-rich executives in their sights than by a desire to protect the public good:

Addressing KKR's [Domnic] Murphy, Labour lawmaker Angela Eagle suggested he paid less tax on his earnings than a maid would.  "Don't you agree it's embarrassing?" she asked.  "You're proud you're paying less tax than your cleaner!"

Is it too much to ask that senior politicians of the world's financial centre bone up on the private equity industry before an investigation like this?  Moreover, the accusatory tone of this debate seems inappropriate, as the industry is simply applying the tax rules of the Treasury as they were intended?

As an industry, private equity has bad knack for perpetuating its opaqueness and making people envious and suspicious.  The coverage of Blackstone's IPO and its lucrative outcome for the top executives there doesn't help.  In yesterday's public hearing, the executives were prepared for an intellectual debate with informed questioners.  But they did not have the right responses to a populist harangue, and they squandered the opportunity to elucidate the industry's structure and economic impact and to gain some public understanding, if not sympathy.  (OK, maybe sympathy is a step too far.)  Instead they came across as defensive and somewhat arrogant. 

So what about the issue then?

I think it is inevitable that both the US (see NYT coverage here) and UK governments will review once again whether to treat the profits generated by private equity partnerships ('carried interest') as capital gains or income for tax purposes.  The difference between the two is significant (40% vs 10% in the UK, about 35% vs 15% in the US). 

To my mind, carried interest is clearly not income.  There is no guarantee it will materialise.  Getting any carried interest requires taking a risk, working an investment for years and often waiting a long, long time for the investment to bear fruit.  The carried interest structure drives the long-term perspective (and commitment) of investment managers, and makes possible long-term investments in a given economy.  The capital gains tax regime was specifically designed to promote long-term investments and as such it should apply also to private equity.

However, it is also true that carried interest is not like investing in equities.  There is only upside for investment managers and no downside risk, eg no money to lose.  As such it is less risky than buying shares and probably ought not to be given the same tax treatment.  But investment managers are exposed to their funds in two ways: through direct investments (the 'GP commitment', typically 1% of fund size) and the carried interest.  Profits on the GP commitment should be treated as capital gains, which is precisely what they are.  The carried interest should be treated as variable income which may or may not materialise.  In that sense it is like a bonus, but with a much longer gestation cycle and more years of 'sweat equity' behnid it.  To be fair, it should be taxed at a lower rate than regular income but at a higher rate than pure capital gains.

What is your equity fingerprint?

Entrepeneurs starting or growing their businesses can find plenty of free advice on the Internet, but precious few practical tools.  The new Web publishing paradigm in the form of blogs, social networks, wikis, etc, is beginning to change that.  For one, we now have a top-notch blog courtesy of Brad Feld devoted to answering entrepreneurs' questions: Ask the VC.   We have Harvard professor Noam Wasserman's compendium of Founder Frustrations.  Then we have the slightly more unorthodox Venture Hacks, which shows entrepreneurs how to subvert some typical investor ruses.

Now startup mentor Philip Baddeley is providing a practical tool for understanding the effects of equity dilution on the value of founder holdings.  The Equity Fingerprint is a way to understand the rate at which the increase in value of your business counteracts your equity dilution as you raise capital.  I'm not sure you can do a lot of real planning with this tool since you can't know the shape of future funding rounds, but it is certainly a useful illustration of a topic which is often misunderstood by entrepreneurs and badly communicated by VCs.

(Thanks Manoj)

Apple's $4bn accident or stock scam?

Here's a squirm-inducing testament to the power of blogs.  Valleywag reports on yesterday's downward 'blip' in Apple's stock price caused by a blog reporting delays to the iPhone release.  The blog note, published on Engadget, was based on a fake internal email that appeared to be leaked from Apple.  The incident momentary wiped $4bn off Apple's market cap.  Om reports on the impact:

In the volatile 23 minutes of turmoil between the minute the disinformation hit the stock market at 8:55 PST and Apple’s announcement that the initial email “is fake and did not come from Apple,” nearly 15 million shares changed hands. That’s 60% of Apple’s normal volume in well under a half hour. That’s also an awful lot money lost for some investors - and gained for others - all of it because of a lie.

Information velocity does have its downside.  I'd like to believe that no one purposely benefited from this event, but that is probably naive.  It does not stretch the imagination to see that unscrupulous traders will get the idea that these blips can be replicated and exploited.  Two factors conspire to create a real structural problem for the public markets here:

1. Rumour moves much faster than anyone's ability to verify or deny (in fact, I'm pretty impressed with Apple's 23-minute reaction)
2. Near real-time trading capability is in the hands of millions of people, and -- more importantly -- billions of hedge-fund controlled dollars

I'm a big believer in unfettered markets and perfect stock pricing that reflects all available information, but today's laws and regulations are not really made to cope with this type of situation.  What will the SEC make of it?

[Credit: Realtimestockquote.com for the chart]

Board of Directors, con't

Here are some more thoughts on Boards of Directors from Brad Feld of Mobius Ventures, focusing in particular on the benefits of having a chairman.  I don't agree that it's always worth having a chairman for growth companies, but if you can get the benefits he describes, it certainly makes corporate governance easier.  I think the biggest challenge (in Europe? in general?) is finding a chairman that is as process-oriented, disciplined and experienced as Brad's ideal chairman apparently is!

Find a use for your Board of Directors

It is surprising how much variability there can be in the effectiveness of board meetings in venture-backed businesses.  The range of attitudes of entrepreneurs to their boards includes:

• a great big yawn
• trepidation at being interrogated
• looking forward to the board as a forum for solving problems

I don't have the experience on both sides of the Atlantic to prove it, but I have a feeling that there are more convoluted, ineffective boards in European growth companies than in the US.  This would make sense, as most European directors (including the entrepreneurs) probably have less board experience than their US counterparts.

Will Price of Hummer Winblad triggered my thoughts on this topic with his recent comment on startup boards which, in his view, too often focus on "status updates" rather than operational strategy and problem-solving.  In my view this applies equally to growth companies at any stage.  The blogosphere has produced some other interesting ideas on this topic, such as Zoli Erdos' comment that boards should collaborate using wikis...

High-tech tools aside, getting a board to function as a productive forum AND an effective instrument of corporate governance is tricky, so here are some thoughts on how to get off to the right start*:

1. Keep it small.

As with any meeting (unlike a lecture), productivity is inversely correlated with group size. We like boards of 5, perhaps 7 at most.  If external non-executive directors (NEDs) are desirable, we recommend picking 1 or 2 (subject to point 2 below).  We even have a few boards of 3 people, which can be very effective for companies where the going is good and speed of execution is the primary determinant of success.

2. Bring in relevant NEDs only.  I mean REALLY relevant!

If the board is going to help the CEO with his key challenges, everyone on it must understand the business and preferably have experience relevant to it.  The most effective NEDs are those that have built a similar business themselves, or that are experts in an operational area of key concern, such as sales, or product development. The most unproductive NEDs are "industry luminaries" whose name adds lustre to the company website but who have little to add to discussions of hiring strategy, development choices, or sales productivity.  If it is industry relationships and customer leads you're after, we recommend forming an industry advisory board to meet a few times a year.

The other most common non-productive NED is the corporate finance specialist or (in the UK) former financial director from a PLC "who is important to the board because he has taken his company public."  This is possibly the worst reason to put someone on your board.  If and when you need corporate finance advice for your float or your M&A transaction you can always hire the right advice in the market.   

3. To chair or not to chair?

It is common in the UK for boards to nominate a chairman, whereas in the US many young private companies operate without a formal chairman role.  Most people find it surprising that even in the UK a chairman is (a) not a requirement, and (b) not necessarily a good thing. 

The chairman can fulfill a number of roles -- he can act as coach and mentor to the CEO; he can mediate among different types of shareholders (eg, investors, founders, angels); he typically sets and hence influences the agenda for board meetings.  The bigger the board the more likely a (good) chairman will help keep it efficient.  But the same rules as in point 2 above apply -- the only thing less productive than a board with non-relevant NEDs is a board with a chairman whose only relevant experience is chairing large boards.

For a small board without a chairman, one Director can "chair" the meeting without necessarily being the permanent chairman, or you could alternate the role of chairing each meeting among the directors.

4. Rely on trust and relationships, not control rights.

Control rights are important and they DO need to be negotiated at the time of investment.  But actually using your control rights in a board setting, ie putting a disputed issue to a vote, is already a sign of a failed board.  The key to good board dynanmics is trust and respect among the participants.  Every conceivable effort should be made to reach agreement by consensus or at least by informal majority.  All directors -- investors, founders, non-execs -- need to work hard to ensure the board steers clear of pushing through measures with votes.

5. Minimise the formal stuff. Spend time on the big issues.

Too often board meetings turn into one-way investor presentations, which is a chore for the CEO and a bore for the directors.  They key is to structure a better agenda and to get directors educated before the board meeting. Once a new board has settled in, organise it such that the formalities and the monthly financial status update are a short routine.  Better yet, get your board members to read the financial pack before the meeting and -- after a brief CEO update -- provide Q&A on the numbers only.  Then you can get down to discussing a the key topics of concern to the business. 

This is also a way to involve members of the management team who are not directors. So, for example, you might want to discuss the trade-offs between two different sets of new product features, so you could invite the product manager to present the alternatives and lead the discussion.

6. Encourage open debate.

Self-evident yes, but is it common practice?  Not really.  If  senior managers are not comfortable voicing their opinions and concerns with the board, then the forum is not working.  Think about restructuring the board, and/or the agenda to ensure open debate is rewarded and the directors and managers can brainstorm without being judged.  This may sound a bit New Age, but in my book a board that doesn't listen will quickly fail to govern effectively.

7. Meet often.

If the entrepreneur feels his board helps him with operational matters and strategy then he won't mind meeting monthly.  Time permitting investors should aim for that (although in reality we typically end up with 8-10 meetings/year).  Frequent interaction both at board meetings and in between is critical to the development of the trust dynamics described above. 

8. Don't always wait to meet.

It is important to recognise that there are topics which are best handled outside of board meetings.  CEO criticism, senior management changes, and other sensitive topics require multiple one-on-one conversations between the relevant board members.  The best forum for raising a sensitive issue to the board is often not the actual board meeting at all. 

If a lot of this sounds like Relationship Building 101 then it's because boards are precisely that: an ad-hoc relationship between people with a common purpose.  How often that common purpose is forgotten in acrimonious (or simply ineffectual) board settings is anyone's guess.

For the entrepreneur the board can and should be a great resource of experience and a source of key support.  For investors a healthy board means an ability for the company to make informed decisions early and to pre-empt problems before they arise.  For both parties this should be an effort worth making.

[* The focus here is on single-board structures as typically found in the UK and US, but these best practices apply equally to dual board structures (Germany, France, etc) where the Supervisory Board (Aufsichtsrat, Conseil d'Administration) acts as the main forum for discussion.]