Weighing In On The Startup Debate: Two Warning Signs

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Weighing In On The Startup Debate: Two Warning Signs

Photo Credit: Kevin Trotman startups

Photo Credit: Kevin Trotman

Before I write this evening, I have updated the blog’s theme so that it is more readable on mobile devices. I’ve tried to preserve most of the best of the former design. Let me know what you think. Also, I have tried to get commenting to work using Jetpack. For those that want to comment, if you can’t, drop me an email, and I will try to work it out. I prefer more interaction than less, even if I can’t always get around to responding.

Mohnish Pabrai On Value Investing, Missed Opportunities and Autobiographies

Mohnish PabraiIn August, Mohnish Pabrai took part in Brown University's Value Investing Speaker Series, answering a series of questions from students. Q3 2021 hedge fund letters, conferences and more One of the topics he covered was the issue of finding cheap equities, a process the value investor has plenty of experience with. Cheap Stocks In the Read More

On to the two warning signs: the first article is The Fuzzy, Insane Math That’s Creating So Many Billion-Dollar Tech Companies. This is about the terms that some private equity investors are getting that help to support current valuations of companies. Here are a few examples:

  • Guarantees that they’ll get their money back first if the company goes public or sells.
  • They can also negotiate to receive additional free shares if a subsequent round’s valuation is less favorable
  • Warrants to allow the purchase of shares at a cheap price if valuations fall.

Here’s my take. When companies try to offer protection on credit or market capitalization, the process usually works for a while and then fails. It works for a while, because companies look best immediately after they receive a dollop of cash, whether via debt or equity. Things may not look so good after the cash is used, and expectations give way to reality.

In the late ’90s and early 2000s a number of companies tried doing similar machinations because they had a hard time borrowing at reasonable rates, or, they wanted to avoid clear public disclosure of their debt terms. In the bear market of 2000-2002, most of these schemes blew up, some catastrophically, like Enron, and some doing minor damage, like Dominion Power with their fiber ventures subsidiary.

When you hear about a guarantee, think about how large it is relative to the total size of the company, and what would happen if the guarantee were ever tapped by everyone who could. If the guarantee is fueled by some type of dilution (issuing stock now or contingently in the future), maybe the total shares to issue would be so large that the price per share would collapse further.

There’s no magic here — there is no good way in the long run to guarantee a certain market cap or creditworthiness. That said, I agree with the article, this sort of behavior comes near the end of a cycle, as does the behavior in this article: Why Bankers Are Leaving Finance for No-Salary Tech Jobs.

We saw this behavior in the late ’90s — people jumping to work at startups. As I often say, the lure of free money brings out the worst in people. In this case, finance imitates baseball: those that swing for the long ball get a disproportionate amount of strikeouts. This also tends to happen later in a speculative cycle.

So be wary with private equity focused on tech, and any collateral damage that may come from deflation of speculative valuations in technology and other hot sectors.

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David J. Merkel, CFA, FSA — 2010-present, I am working on setting up my own equity asset management shop, tentatively called Aleph Investments. It is possible that I might do a joint venture with someone else if we can do more together than separately. From 2008-2010, I was the Chief Economist and Director of Research of Finacorp Securities. I did a many things for Finacorp, mainly research and analysis on a wide variety of fixed income and equity securities, and trading strategies. Until 2007, I was a senior investment analyst at Hovde Capital, responsible for analysis and valuation of investment opportunities for the FIP funds, particularly of companies in the insurance industry. I also managed the internal profit sharing and charitable endowment monies of the firm. From 2003-2007, I was a leading commentator at the investment website RealMoney.com. Back in 2003, after several years of correspondence, James Cramer invited me to write for the site, and I wrote for RealMoney on equity and bond portfolio management, macroeconomics, derivatives, quantitative strategies, insurance issues, corporate governance, etc. My specialty is looking at the interlinkages in the markets in order to understand individual markets better. I no longer contribute to RealMoney; I scaled it back because my work duties have gotten larger, and I began this blog to develop a distinct voice with a wider distribution. After three-plus year of operation, I believe I have achieved that. Prior to joining Hovde in 2003, I managed corporate bonds for Dwight Asset Management. In 1998, I joined the Mount Washington Investment Group as the Mortgage Bond and Asset Liability manager after working with Provident Mutual, AIG and Pacific Standard Life. My background as a life actuary has given me a different perspective on investing. How do you earn money without taking undue risk? How do you convey ideas about investing while showing a proper level of uncertainty on the likelihood of success? How do the various markets fit together, telling us us a broader story than any single piece? These are the themes that I will deal with in this blog. I hold bachelor’s and master’s degrees from Johns Hopkins University. In my spare time, I take care of our eight children with my wonderful wife Ruth.
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