Business Finance from Google Ventures

With

business finance

becoming an attractive option for many organisation with cash to spare, In March of 2009, Google unveiled its latest undertaking: Google Ventures. Google Ventures is a Google-backed venture capital group that aims to invest in new and exciting business plans. Funding is open to any company with a great idea, and the idea needn't be computer-based.

What is Google Ventures?
Google Ventures is a venture capital firm designed to provide funding to new businesses with exceptional ideas. Google Ventures, managed by Rich Miner and Bill Maris, has a starting balance of over $100 million dollars, and over 20,000 "exceptional Googlers" evaluating prospective businesses.

Google Ventures can provide funds ranging from seed money to millions of dollars in start-up capital to businesses they believe have the potential to be great. As an investment company, they are of course looking for businesses that will provide them with a return on their investment. However, they stress that they are also seeking innovative and creative companies who tackle problems in new ways.

Google Venture and Startup Companies
The aim of Google Ventures is to seek out potentially great companies under the leadership of entrepreneurs who will go on to do remarkable things. Google Ventures states that they are primarily interested in funding software companies, biotechnology companies, and companies in the consumer Internet industry Google Ventures operates separately from Google and investments do not have to be directly related to, or tie into, Google's Vision. Instead, they seek to maximize returns.

Only companies within North America are eligible for funding form Google Ventures as of 2009. Start-ups interested in being considered are urged to contact the company via email with a presentation or proposal. The website requests that proposals be limited to either twenty slides or no more than three typewritten pages, and cautions prospective business owners that they will respond only to companies they are interested in speaking with further.

Goals of Google Ventures
While Google is not new to investing, Google Ventures is different. Google will be using Google Ventures as their primary vehicle for making venture investments.

Google Ventures acknowledges that great ideas are not subject to recession or hard economical times. Ideas don’t stop, however the backing to make them become a reality does. In the face of economic downturn in 2009, Google is offering funding because they believe it is the time to invest in companies that have the chance to become "the next big thing." Google was founded by entrepreneurs, and they believe they should now help the future icons of the next generation.

Companies Helped
Google Ventures' first investments were made in April 2009. Pixazza was the first company offered funding by Google Ventures. Pixazza's core business is Internet advertising using pictures. Their business model involves transforming static images into interactive advertising vehicles. Consumers can "mouse-over" a picture to learn more about things they are interested in, or buy products they see.

Silver Spring Networks, whose core business is in smart grid technology, was next in line and in August of 2009, three more investments were made to Altarock, Brightsource Energy and eSolar, three alternative energy companies.

Read more: http://www.brighthub.com/office/entrepreneurs/articles/50275.aspx#ixzz0UnGnjjQW

Equity Risk Premiums: An Update

As many of you are probably aware, I am fixated on equity risk premiums. To me they are at the center of almost every debate about equity markets - whether stocks are too low or too high, whether current market conditions are the norm or an aberration, and whether equity investors truly understand the risk associated with investing in equities.

I had a few posts during the crisis, where I noted that the implied equity risk premium for the S&P 500 had climbed at a rate never seen before in history during the twelve weeks between September 12, 2008 and late November. In fact, I reported an implied equity risk premium of 6.43% at the start of 2009, up from 4.37% at the start of 2008. The big debate at that point was whether this crisis had damaged investor psyches so much that it had caused a permanent upward shift in risk premiums, or whether this was just another bump in the road and that we would revert back to the 4% implied equity risk premiums, pre-crisis.

I have just posted an updated version of my equity risk premium paper online:
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1492717
In the paper, I graph out the implied equity risk premium from January 2009 to September 30, 2009. On September 30, 2009, the implied equity risk premium stood at 4.86%. While I had anticipated at the start of the year that the premium would drift back down, I expected it to take much longer than 9 months. One more reason for constantly updating equity risk premiums! Markets are full of surprises.

The new debate that is unfolding is whether markets have gone up too far and too fast, thus exposing themselves to a correction. I don't know the answer to that question but it can be framed around the implied equity risk premium. If you think that the crisis should have changed people's attitudes about risk and that a 6% equity risk premium is the new steady state, markets are over bought and the correction will be painful (a 15%-20% drop in the S&P 500). On the other hand, if your view is that what happened last year is just part and parcel of equity risk and that investors will soon forget the scars and go back to the 4% risk premiums of 2007 and 2008, the bull market has a lot of steam left on it (a 10% up movement in the S&P 500). I am not giving away too much when I say that the long term equity risk premium that I am using for mature markets, when valuing companies, has been 5-6% since January 2009. At its current level of 4.86%, I am within reaching distance, but I will respond to the market on this number. I am not a market timer!

Bond Ratings: Why, how and what next?

In the aftermath of the bond market calamities (for investors and issuing companies), the ratings agencies (S&P, Moody's and Fitch) have come under assault from all sides. Legislators and regulators have accused them of being too close to the companies that they rate, with the implication that companies/bonds are being over rated. Academics have piled on, arguing that there is little information in bond ratings and that ratings agencies offer poor and delayed assessments of default risk. Finally, a few former employees have come forward with claims that bond ratings, at least in some cases, are stale and not backed up by serious research.
http://www.nytimes.com/2009/10/11/business/economy/11gret.html

I would like to at least step back and consider some broad issues related to ratings:

1. Why do we need bond ratings in the first place?
As long as there have been people on the face of this earth, there have been lenders and borrowers. For much of recorded time, a lender (money lenders in ancient times, banks in more recent periods) assessed the credit quality of a borrower and set the interest rate accordingly. It was the advent of the bond market in the last century that changed the dynamics and created the need for ratings agencies. When a company issues bonds and investors price these bonds, these investors do not have the resources to assess credit risk on their own. Ratings agencies stepped into the gap and provide this credit risk assessment. Thus, the ultimate service provided by bond ratings is to bond traders, and bond issuers benefit only indirectly.

2. What is the information content in a bond rating?
Ratings agencies have access to all of the financial information that the rest of us do - financial statements, past and present, analyst reports, industry analysis etc. In addition, they can ask for private information specifically related to default risk, which can then be used to finesse or modify the rating. The problem with the private information is that it comes from the management of the firm, which of course has an interest in providing more good news than bad news.

The simplest way to measure whether the market thinks there is information in a bond rating is to look at whether market prices of bonds change when their ratings are changed. The evidence there is mixed. While there is a consistent price change, with bond prices increasing (decreasing) on bond upgrades (downgrades), most of the price change seems to happen before the rating is changed. In other words, markets seem to anticipate ratings changes. That does not make ratings less useful but they are often lagged measures of default risk.

3. Is there a potential for conflict of interest and bias in ratings?
Going back to the origins of ratings, it is clear that bond buyers should be the ones paying for the ratings and they do so now, albeit indirectly. Ratings agencies are compensated by the companies that are rated, which does create a conflict of interest, though the conflict is nowhere near as intense as some other conflicts that bedevil us (such as auditors who have consulting revenue from the companies they audit or investment banks operating as deal makers & advisors on M&A deals). The price paid by companies is a relatively small one (3-5 basis points of the size of the issue) and it is not as if companies that are down graded can pull up stakes and refuse to be rated. (Let's face it. There are more ratings downgrades in a quarter than equity research analyst sell recommendations in a decade.) The price paid by companies is then passed on to bond buyers as a slightly higher interest rate on the bond.

There is a bigger potential for conflict of interest with mortgage backed securities and other bonds that are issued against pools of assets, not by companies by often by intermediaries. There, Moody's and S&P do have an interest in growing the market and attaching higher ratings does increase market growth, which increases future revenues and so on...

There is much talk now of changing this model but the alternatives are not that attractive. One is to charge a small tax on every bond sold, collect the proceeds in an entity (probably government run) which will then pay the costs to have all bonds rated. The question then becomes choosing the ratings agency (ies) to do the rating and the pricing mechanism (fixed price, auction). The other is to increase competition among ratings agencies, with the argument that competition will make them worry about getting rating right, though this would exacerbate the conflict of interest, at least in the short term.

4. What should we do going forward?
Before we pile on ratings agencies and blame them for our bond losses, we have to recognize that they were not the only ones to under estimate default risk. Most banks in developed markets made the same mistake, as is clear by the losses being written off on loan portfolios. Thus, I would not blame the ratings mistakes primarily on conflicts of interest or poorly trained ratings staff or some conspiracy the0ry too dastardly to behold. Rather, I think ratings agencies were caught up in the mood of the moment, just as the rest of world was, where housing prices always went up, people had permanently stopped defaulting and recessions were a thing of the past.

In closing, my fear is that we will throw the baby out with the bath water and make radical changes in the ratings process. Having valued companies in markets with bond ratings and in markets without, I can tell you with absolute conviction that I would rather deal with lagged and flawed bond ratings than no bond ratings at all.

Crisis Lessons: Presentation...

A few posts ago, I mentioned that I was working on a presentation reflecting the lessons that I learned from the crisis. I had also promised to post the presentation when it was ready. You can get it be clicking on the link below:

Market Revelations: Lessons learned, unlearned and relearned from the Crisis

While you can read about the specific lessons that I have taken away from the last year in the presentation, here are the general points I want to make:

1. These are the lessons that I have learned. In other words, this is my personal odyssey and I do not expect everyone to have learned these lessons, nor do I feel the urge to impose them on others.

2. The common theme across the many lessons is that I am much more wary about using past or historical data, whether it be at the company level (profitability, risk etc.) or at the macro level (equity risk premiums). Mean reversion, i.e., the assumption that numbers revert back to historical averages, has served us well, at least in developed markets for a long time, but a blind adherence to it can decimate companies and portfolios.

3. At a gut level, I feel that I have a better understanding of risk and the need for risk premiums now than before the crisis. Fundamentally, I believe that this crisis was precipitated by a belief that we can measure and control risk, when the nature of risk is that it cannot be ever fully measured or controlled.

4. I would not classify myself as a behavioral economist, but I am more willing to give behavioral finance a place at the table when we think about solutions to corporate finance and investment problems, after the crisis, than before.

The bottom line is that I feel humbled by all the things I do not know about finance and markets and excited at the prospect of exploring these things more.

Leveraged Buyouts

Yesterday's New York Times had a story (a sad one) on the troubles at Simmons, a mattress company with a long and illustrious history in the United States.
http://www.nytimes.com/2009/10/05/business/economy/05simmons.html
In short, the company was targeted for a leveraged buyout by Thomas H. Lee Partners, a private equity firm, in a transaction that went awry, partly because of miscalculations by the investors and partly because of the market crisis. The article is clear about who the "bad guys" in this story are and it is the private equity investors, who profited while a good company and its employees were destroyed.

I am always suspicious when the financial press sees things in black and white, since my experience is that life is full of shades of grey, but this article gives me a chance to vent about leveraged buyouts. If the message here is that private equity investors act in their self interest, my reaction is "Duh! Who does not?". If the message is that debt is the enemy, I am afraid the culprit is not Thomas H. Lee, but the tax code, which is tilted towards debt for some reason that I cannot fathom in pretty much every market in the world.

My problem with the way leveraged buyouts have been framed by both its proponents and opponents is the focus on leverage as the center of the transaction. To me, there are three components to a leveraged buyout:
a. The change in financial leverage: Changing the mix of debt and equity can help you exploit the tax code and increase your overall value (at the expense of taxpayers).
b. Control: In badly managed firms, changing the operating characteristics, i.e. investment and dividend policy, of the firm can increase value,
c. Public to private: To the extent that being a publicly traded firm forces you to make decisions to satisfy stockholders and analysts focused on the short term (at least in theory), going private may allow firms to make hard decisions that increase their value.
A good candidate for a leveraged buyout will derive value from all three levers. It will be an under levered, poorly managed firm, where there is a substantial gap between managers and stockholders.

In a blog post from November, I pointed to an extended treatise on the topic, where I look at an LBO transaction that failed, where Goldman and KKR tried to take Harman Audio private, and failed. My conclusion was that Harman was the wrong company to target for an LBO, because it did not have significant excess debt capacity, was already fairly well managed and a big stockholder was the CEO of the company.
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1162862
What does this have to do with Simmons? I think that we are making a mistake when we assume that private equity investors are brilliant villains in LBO transactions. For every winner (like Thomas H. Lee in this specific transaction), there are many losers, and I would not be surprised if private equity investors are not net winners in this process.

The dangers of relative valuation

In my last post on Twitter, I hypothesized that the valuation of Twitter was based upon what investors had assigned as a value for Facebook a few months earlier. I want to make clear that I am not suggesting that this is a good way to value businesses but that it is the status quo.

With relative valuation, the dangers of a bad initial valuation cascading into subsequent valuations is high and they get worse when the initial valuation is of a large company (Facebook is large, by the standards of networking sites) and done by what is viewed as a reputable source (private equity investors have an ill deserved reputation for valuation expertise and a big investment banking name helps..) In fact, this may be one reason for pricing bubbles in sectors.

I can carry the relative valuation lessons here to an absurd limit. I have 15,000 + members on the mailing list for my website (damodaran.com). I would argue that this is a fairly valuable potential list for anyone with an investment or valuation product. Applying the $32.5/member to each member (a bargain, given the selection bias), my site should be worth half a million. Any takers? Better still, why not just your add your name to my mailing list and increase my value $32.5 by doing so? (The incentives for sites to seek out new members, even if they are idle and do nothing, is extremely high...)

I am kidding here, since I have no intent of making my site commercial. I have always argued that relative valuation, at least as it is practiced, is a sign of laziness because analysts are not only sloppy but throw out much of the data that they have access to. Relative valuation, done right, where you use not just the averages, but also look at the differences in valuations across companies to draw lessons about how the market values assets, can be a very useful tool in valuation.

What is Twitter worth?

Yesterday's big news story, at least in valuation circles, is that private equity investors have invested $ 100 million in Twitter for a roughly 10% stake, suggesting a billion-dollar valuation for the nascent company.
http://blogs.wsj.com/deals/2009/09/24/breaking-news-twitter-to-raise-100-million-from-insight-t-rowe-price-other-investors/
Twitter, for those who may be living in the middle ages, has about 30 million members who post short messages (less than 140 characters) that other members can read (if they choose to follow your tweeting). Every celebrity (sports, politics, media) seems to be tweeting now. There are three questions that came up after the story:

1. How did the equity investors in Twitter come up with the $ 1 billion value?
We assume degrees of sophistication to private equity investors and venture capitalists that they usually do not possess. In my experience, venture capital valuations often represent back-of the-envelope computations with hefty discount rates (target rates if 30-60%) taking care of the uncertainty. I was not privy to the valuation of Twitter but I can read the tea leaves and guess how they valued the company. A few months ago, Facebook (a company that Twitter aspires to be at least in the new term) raised equity from a group of Russian investors, who attached a value of $ 6.5 billion to the company. At the time. Facebook had approximately 200 million members, which works out to about $32.5/ member. As of last week, Twitter had about 30 million members. Applying the $32.5/member to this estimate, I get $975 million (suspiciously close to $ 1 billion). This may be pure coincidence but given the pull towards relative valuation on the Street, I think it may explain the valuation.

2. Could Twitter be worth $ 1 billion?
"Could" is a very weak word. Of course! What Twitter has going for it is the numbers. With 30 million members, all I need to be able to do is to generate a small cash flow from each one and the valuation will be justified. A billion dollar value for a firm requires that the firm be able to generate about $ 100 million in operating income in steady state. (I am applying a 10% cost of capital, typical of mature firms, and assuming zero growth). With 30 million members, that works out to $3.33/year from each member. If you are a Twitterer, the question I would have for you is this: Would you be willing to pay an annual membership fee of $ 5 or $ 10 to follow your favorite celebrities thoughts? If the answer is yes, the billion dollars is paid for... If not, I will keep looking...

3. Is Twitter worth $ 1 billion?
Interesting question. As an ongoing business, I don't think so and here is why:
a. You don't buy a business that does not have a business model yet. Twitter has a lot of members but it really does not know how to make money of these members (yet). Advertising alone will not do it. Any blatantly obvious way to earn money (such as charging per tweet) will very quickly decimate the membership. So, where will the additional profits come from?
b. You are buying a business that may be a fad, at the peak of its faddishness: Twitter is hot right now, because it is in the news. However, most of the tweets that I read are inane: it is tough to be profound 24 hours a day and to express that profundity (is that even a word?) in 140 characters.

However, I think that you can justify a $ 1 billion value for Twitter at least to some investors and that is to think of it as an option. What you are buying then, when you buy this firm, is access to 30 million potential customers, who may not know each other but are tied to one another. There are at least two types of investors who may find this investment appealing:
a. A firm with deep pockets and products/services that may be appealing to the membership of Twitter. The 30 million members of Twitter tend to be techno-savvy, older than Facebook members (on average) and well off. They also tend ot think well of themselves or at least their opinions. To illustrate, Microsoft did take a position in Facebook a few months ago and I can see other companies with products (especially in entertainment) do the same with Twitter.
b. Risk money: While no investor in his right mind should be investing the bulk of his portfolio in Twitter, it may be a good investment for risk money, i.e., money you want to invest in high risk, high reward investments and are willing to lose. Spreading your bets across multiple investments like Twitter may create a portfolio that has a good risk/return trade off, especially if you can bring some selection acumen to the process.

P.S: Facing the scorn of my teenage daughter, I created an account on Twitter about 6 months ago. I have never tweeted but I have 228 followers. Scary!!!!