It's time to end the FASB (and shake up the SEC)

Recent "revelations" concerning the Lehman debacle highlighted a very important point: media and regulators alike have had their heads in the sand for decades. The headline of a recent New York Times article plainly makes the point: "Findings on Lehman Take Even Experts by Surprise." If this is really true, it is quite an indictment on either the lack of intelligence or truthfulness of our regulators. Sadly, either one could be the case.

Between lobbying dollars and entrenched interests, our financial regulatory regimes have become so perverted as to have little basis in reality. I recently penned an Op-Ed in the Financial Times where I made the point that all the clamor and criticism around derivatives was ill-founded, that financial transactions completely divorced from derivatives could and have caused even more damage than derivatives themselves. The Lehman example is a case in point. This is not a story about derivatives, no more than Enron was a story about derivatives. But the key take-away should be that if our rules and regulations are so porous as to allow transactions like Lehman's to gain approval from their "blue chip" legal counsel and expensive "Big Four" accountants, then there is a serious problem with the state of our regulatory framework.

The SEC is a highly politicized organization and the Financial Accounting Standards Board (FASB) is a kind of self-regulatory organization that is ultimately a stooge of industry. Consider this, taken directly from the FASB website (bolding my own):

Since 1973, the Financial Accounting Standards Board (FASB) has been the designated organization in the private sector for establishing standards of financial accounting. Those standards govern the preparation of financial statements. They are officially recognized as authoritative by the Securities and Exchange Commission (SEC) (Financial Reporting Release No. 1, Section 101, and reaffirmed in its April 2003 Policy Statement) and the American Institute of Certified Public Accountants (Rule 203, Rules of Professional Conduct, as amended May 1973 and May 1979). Such standards are important to the efficient functioning of the economy because investors, creditors, auditors, and others rely on credible, transparent, and comparable financial information.

The SEC has statutory authority to establish financial accounting and reporting standards for publicly held companies under the Securities Exchange Act of 1934. Throughout its history, however, the Commission’s policy has been to rely on the private sector for this function to the extent that the private sector demonstrates ability to fulfill the responsibility in the public interest.

Do we need any more examples of the private sector's inability "to fulfill the responsibility of public interest?" I think not. The FASB has accumulated exceptional power and influence over the years, yet has merely served as an appendage of those whom it was supposed to be regulating. Consider further these points made on the FASB website:

To accomplish its mission, the FASB acts to:

• Improve the usefulness of financial reporting by focusing on the primary characteristics of relevance and reliability and on the qualities of comparability and consistency;
  
  
• Keep standards current to reflect changes in methods of doing business and changes in the economic environment;
   
• Consider promptly any significant areas of deficiency in financial reporting that might be addressed through the standard-setting process;
  
  
• Promote the international convergence of accounting standards concurrent with improving the quality of financial reporting; and
   
• Improve the common understanding of the nature and purposes of information contained in financial reports.

Has the FASB really acted to improve usefulness, kept standards current, considered promptly any significant areas of deficiency and improved common understanding? It is pretty clear that they've broken almost every one of their stated precepts, and the SEC has been complicit in allowing this charade to continue. Someone has to call these people out and demand a change. And I am calling for nothing less than a complete de-certification of FASB and the creation of a new group of practitioners that have no linkage to industry whatsoever. Because we can't continue with a regime that is so clearly biased and ineffective, and which has been instrumental in permitting the spate of financial "revelations" to continue apace. I think this group needs to be a mix of accounting practitioners and theorists, with the practitioners coming from the ranks of those who have gamed the system for years. Because they know best how to plug the holes that they themselves marched through for the benefit of their firms and their firm's clients. It is akin to taking an accomplished hacker and putting them in charge of an NSA Tiger Team focused on preventing network intrusion. Who better than those who have beaten the system to fix the system?

I ultimately think this group should be part of the SEC, but that the SEC itself needs to be re-tooled. Lifelong politicos need not apply. It also needs to be staffed by practitioners who are pragmatic and beyond the influence of lobbyists and the like. They can have no conflicts with legacy firms through shareholdings or contractual relationships. The last thing we need is another Geithner/Paulson replay where their integrity and judgment is questioned at every turn because of ties to prior firms. We need people who really understand the markets and view such a position as an opportunity to impose ground-breaking change and to create a legacy of common sense, pragmatism and integrity. It would a refreshing change to the political morass that the SEC has become.

I have written many posts about changes to improve transparency, efficiency and fairness in both regulatory and accounting rule-making, but here are five issues (plus a bonus issue) I'd like to see changed - tomorrow.

1. End off-balance sheet transactions. If the substance of a transaction is a sale with all the risks and rewards of ownership transferred to another party, then take the asset and related liabilities off the balance sheet. But if there is some risk retention, even if it is structured to be "remote" (e.g., a sharp ratings downgrade; you see where that got firms like Citigroup, etc.), the assets and liabilities need to remain on-balance sheet. This would also end the use of securitization as a vehicle for improving balance sheet presntation. Debt is debt, regardless of where the obligation is housed. This covers the "Lehman type" transactions as well as those entered into by Enron and myriad municipalities. Substance over form must rule.

2. Impose mark-to-market accounting on bank balance sheets based upon asset funding. Financial assets should be marked-to-market. This has been a hotly contested issue for reasons that baffle me. Bottom line: if a financial firm does not have the financing in place to carry an asset to term, then it has to be marked-to-market. Mortgages and illiquid investments funded with short-term liabilities should not be able to be carried at cost. It creates an accounting charade that hits at precisely the worst time - when financing is hard to get and the assets are unable to be sold. But if stable financing is in place and the asset can (and is intended to) be carried for the long-term, then by all means reflect it at historical cost (less a haircut for permanent impairment).

3. Move over-the-counter derivatives transactions to exchanges. This is black-and-white; the fact that there are detractors to this shift amazes me. The focus should be on standardizing derivative instruments (interest rate and foreign exchange swaps and options, credit default swaps and options, etc.) and making the use of over-the-counter derivatives prohibitively expensive through capital requirements. The OTC clearing house approach would include posting of initial and variation margin, with margin thresholds that are routinely changed based upon changes in the volatility of the hedged instrument. We have the technology and the math to be able to do this. We should move towards this regime change immediately.

4. Create a cap on derivatives to be written equal to the physical underlying. A big part of dislocations in the credit derivatives market relates to the derivatives written being a multiple of the underlying asset. It theoretically and practically makes no sense that, for example, $5 billion of credit derivatives should be written on a $1 billion bond issue. This can create both increased volatility and increased risk of market failure upon settlement. This cap should be an immutable fixture of the derivatives markets.

5. Enact common sense rules regarding the capital structure of financial institutions. The suggested changes above will help better define the true liabilities of financial firms. But the one missing piece is the mismatch between the assets and liabilities of many firms, creating massive gaps in both interest rate and liquidity risks that have consistently brought down firms for generations. Whether "riding the yield curve" (lending long/borrowing short) and bleeding cash/draining capital when short rates spike (thousands of S&Ls in the 1980s), or getting into a liquidity crunch when asset values decline and short-term funding sources dry up (Bear Stearns, Lehman, etc.), this is a dangerous practice that has to be stopped. Maximum liquidity gaps need to be imposed, as well as policies around "Too Big to Fail" (TBTF - the source of a future post). These policies along will substantially enhance the stability of our financial sector, and create a more sustainable (though less profitable) industry.

Bonus issue: Eliminate the flawed financial presentation of leasing. This is related to (1) above. The hard-rules differentiating between operating (off-balance sheet) and capital (on-balance sheet) leases has created a multi-billion dollar industry more focused on accounting presentation than economic efficiency. If the substance of a lease is really a loan, then both the asset and the associated liabilities should be on the balance sheet. The threshold of what constitutes a "capital lease" (booking the asset and liability) should be sharply reduced to prevent transactions that fundamentally give rise to a debt-like obligation to be treated merely as a lease payment.

This is intended to be the start of a conversation, but one which is important and cannot be pushed aside or politicized any longer. The safety and stability of our financial system depends on it.

ADDENDUM

In the wake of my post, I just had an email exchange with the Director of Communications of the Financial Accounting Foundation/Financial Accounting Standards Board. I am posting the exact exchange below. I find his inquiry both interesting and depressing, as he is focusing on quite possibly the least important part of the issue at hand and avoiding the substantive parts (because there really aren't many good arguments against the substantive parts, I guess). He wants me to say "I made a factual error" because the rules for off-balance sheet accounting were changed last year, and I put it on my laundry list of things that need to be remedied. My intention was to raise awareness of the issue as most people don't read new FAS releases. However, if my characterization was misleading to my readers my apologies. And apologies to the FASB if I didn't give them credit for something that was done last year that should have been done more than a decade before. Anyway, here is the exchange:

FASB: Your credibility as an opinion columnist would be greatly helped if you did your homework before writing. Off balance sheet transactions were largely ended last year by the FASB under FAS 166/167. This was the number one complaint you voiced about the organization. The new rules were BIG news--they got lots of national news coverage that continues. I guess you missed it.

Roger: Your organization would have far more credibility if it was forward-looking and principles-based, not merely reactive in the face of withering public pressure. I am quite aware of FASB's changes. My article extends far beyond your single point, and is an indictment of the way the body itself functions and its self-regulatory nature. The FASB is no better than the rating agencies, Neal. I appreciate your position and motivation to defend it but as a Wall Street practitioner for almost 20 years I have a pretty good idea of FASB's past, present and (likely) future if it is not forced to change. It has not covered itself in glory.

FASB: Yes, your article does extend beyond a single point. And I defended nothing else except the fact that one of your article’s key points—is wrong and misleading. You blew it in terms of what you told your readers about off-balance sheet transactions. It would be nice if you admitted it.

Roger: It's not inaccurate. You are interpreting "keeping standards current" as being what FASB changed last year. That is like calling the fire department after the barn has burned down. Had FASB been keeping current, it would be seen these types of transactions being promulgated (and they started well more than a decade ago; I touched the structured product world from 1987-2001) and changed the rules in anticipation of abuse, before something catastrophic happened. That is not what happened. I stand by my opinion and believe it to be factually correct in all respects.

FASB: You wrote about rules that you would like to see changed tomorrow. The first one was “end off-balance sheet transactions.” They were ended last summer. Can you give me a small break here?. That’s wrong Roger. You’re making the case in your piece that they should be ended. And they already were months ago. That’s like writing a column now that George Bush should not be re-elected. It’s just my two cents, but your readers would probably appreciate it if you admitted a mea culpa on that. I’m not asking you to change your opinion about us. Just pointing out a big mistake you made.

Roger: It's not really a mea culpa - my blog is designed to raise broad awareness of issues, and that is what I did. That said, I never want to be accused of being anything less than forthright, and if my prose lacked clarity I am more than willing to make the clarification.

So readers, consider the issue clarified.

IA Venture Strategies - now on the Web

While I have written a bit about my new fund, we have not had a web presence - until now. Please check out the new website. You will learn more about our mission, investment approach and the team. We still don't have much on the portfolio page as several of our companies are still in stealth mode, but what I can say is that we've already closed deals or have signed term sheets with companies in the realms of predictive analytics, database systems, intrusion detection and advertising technology. We are currently pursuing deals in cloud-based data distribution, data normalization and an array of related domains. Our portfolio companies are based in New York, Boston, Los Angeles - and soon to include San Francisco and London. I continue to be shocked by the amount of high-quality global deal flow across the big data realm, and as long as we see strong seed-stage deals being led by super smart, experienced and passionate entrepreneurs with vision, we will continue to deploy capital at a healthy pace.

The team is still pretty frantic closing the fund, investing in and working with our companies and just generally figuring out how to best run a fund of our size and scope. The work is virtually endless, but it is the best kind of work there is. We are working towards setting up office hours, but are not quite there yet. We also have lots of job opportunities at our companies, but that utility is not yet active on the site. My colleagues Ben Siscovick and Brad Gillespie agreed that we should have a bias towards action, getting the site up and out there even though it is a work in progress. We'd love your feedback and suggestions as we are new at this and want the site to be useful and informative for entrepreneurs, venture capitalists and media alike.

Hopefully the site helps clarify some questions about the fund, and will serve as a reference point for those considering a raise from big data domain experts who roll up their sleeves and have strategic Limited Partners who do the same. Having a baked-in set of relationships with top firms with big data problems is pretty unique among venture funds, especially one as small as ours. But creating this big data ecosystem was an essential part of my strategy to help solve the generational problems arising from the onslaught of data and information. We are in the early-innings of what is likely to be an extra-innings contest, and Ben, Brad and I are laser focused on helping to be part of the solution to these seemingly intractable problems.

Please continue to check back as we make improvements to our site and grow our business. I will also keep you posted on this blog and at @infoarbitrage as well. I will likely write one more post about the fund and its LPs after I do a final closing, but for now let me say that starting a fund has been among the most satisfying things I have ever done. And it helps having two great partners like Ben and Brad helping to make our vision of improving the management and extraction of value from big data a reality.

A new model for investing in "social"

I had the pleasure of sitting on a panel last night sponsored by GoodCompany Ventures, a very interesting shop that helps entrepreneurs with a "social investing" (but not necessarily a non-profit) mission get their start with advice, mentoring, and sometimes capital. I sat on the panel with some outstanding thinkers including Jacquie Novogratz (Acumen Fund), Fred Wilson (USV), Jacob Gray (Murex Investments) and Scott Edward Anderson (The Green Skeptic). I had never spoken on the topic of "social investing" before and, quite frankly, didn't exactly know what it meant except I that generally thought of the term as pejorative from an investment perspective. Social investing? This means not really generating attractive returns, right? Well, after last night's discussion and thoughts that came to me on-the-fly during the debate I have a very different perspective on what this burgeoning asset class really means, and how it has the potential to change the world in an array of positive ways.

First of all "social investing" is a really dumb term. If you're going after conventional for-profit investors the social moniker will kill the pitch every single time. Fred Wilson raised an interesting point about the difference between short-term and long-term profit maximization. He is personally willing to take the long view on building an attractive, sustainable business even if its goal isn't maximization of short-term profits (read: Etsy). And, in fact, he cites personal examples of companies that have been short-term profit maximizers that flamed out because of unhealthy business practices. But I think the issue is more fundamental than that. Many of the companies being incubated by GoodCompany or funded by Jacquie's Acumen Fund wouldn't make the grade even on the terms Fred laid out. It's not strictly a short-term/long-term issue. It's an issue of how you define capital and return.  

My hypothesis is that we need a whole new regime for quantifying the value of businesses that have goals other than strictly financial profit. We need hard numbers - real metrics - to demonstrate the value of initiatives that create value for society beyond the payment of staff and the generation of profits for shareholders. For instance, Jacquie brought up the example of a company Acumen funded that provides treated mosquito netting for families in Africa. These nets provide people from getting malaria, saving enormous amounts of money on acute health care and work time lost, while insuring economic productivity among the youth for their lifetimes that otherwise could have been cut short by infection and disease. These benefits are able to be quantified: we have the economic data to do the crunching, and the econometric modeling techniques at our disposal to quantify the ROI of these investments. But the "R" - the return - isn't simply financial profit: it's economic utility, real benefits being enjoyed by society. These are the terms we should be used to define the benefits of this kind of investing - this asset class - which really does need to be viewed as an asset class separate and distinct from businesses principally focused on financial returns.

So if the appropriate measure is economic utility (which encompasses both financial and social profits), how should these businesses and initiatives be funded? I would argue that it should tap into capital from two key sources: Government and funds that have traditionally gone toward conventional philanthropy. Fishing around in the traditional for-profit pond is a waste of time: utility in this sphere is generally uni-dimensional - profits first and last. Let's be honest. Investing in this asset class has the potential to generate traditional financial returns, but they are tenuous. And if this is the benchmark by which capital is allocated among projects, many critical projects will go unfunded because the measure is wrong. So if we can all shed the stigma of "social investing" and acknowledge that you can still "invest" and "do philanthropy" at the same time, I think it would go a long way towards improving the messaging of this vitally important asset class. I see this approach as addressing the capital allocation problem among philanthropies. By taking a disciplined, numbers-based approach to quantifying cumulative benefits, it will become increasingly clear which businesses with a social mission should attract investment capital and which should not. It will no longer simply be a marketing issue, but one grounded in logic and reason. Will some projects go unfunded that would otherwise have attracted capital because of its PR? Yes. But will many more important projects get done that otherwise would have gone unnoticed because they might have a low Q score but massive economic utility? For sure.

These are only my initial thoughts on this topic. I will definitely be applying more mental cycles to these incredibly important issues. I'm looking forward to both stimulating and participating in this critical dialogue.

Does being a VC mean "trying to change the world?"

My friend Chris Dixon just wrote an interesting post titled It's not East Coast vs West Coast, it's about making more places like the Valley. It is very interesting and provocative, and as with all Chris's posts, it's a must-read. However, it honestly rubbed me the wrong way and prompted me to write the following comment:

Chris, I think it comes down to what being a VC really means. You seem to equate the VC mission with "making things that change the world." I believe this is a narrow and potentially dangerous definition, and actually highlights one of the biggest problems with the Silicon Valley venture scene. It also, in my experience, doesn't reflect the true dynamics of how large-scale West Coast VC works, which is a lot less sexy and entrepreneur-friendly than you indicate.

Should a good VC be working to fund ideas that change the world? Yes. Should they also be looking to back young companies working on important problems that are, say, built on top of something else and very useful but not transformational? I'd say so. There are lots of start-ups of value that will never be the next Google, Twitter, Microsoft or Apple, but that doesn't mean they shouldn't be funded and nurtured as any start-up should. If one were to apply the "change the world" mission to venture investing, the amount of capital being invested in such companies (or even that should be invested in such companies) is probably less than 20%. To me the key is making sure that those 20% or so get the requisite support and time to thrive from their venture backers, which is the much bigger issue at hand.

I'd like to think that I back worthwhile start-ups and am very entrepreneur-friendly without all that negative financial engineering you ascribe to certain East Coast VCs, but do most of my portfolio companies have a chance to change the world? Not in the way I define changing the world. And personally, I'm ok with this. I'm helping to create useful products, create jobs, and foster entrepreneurial excitement and possibilities. This is what venture investing means to me.

As it relates to large West Coast VCs, many of these firms are structurally bound to trying to change the world because they need those kinds of wins to return their funds. This doesn't make them paragons of virtue; it makes them rational. But buying this series of far out-of-the-money call options has an ugly dark side as well: if companies don't appear to have the potential to change the world (read: sell for $1 billion+, go public, etc.), they often get squashed and orphaned since they are no longer worth the VCs time. Now I'm painting with a broad brush here but you get the point. Does this dynamic help create a favorable entrepreneurial culture? Is this approach really making the world a better place? Not to me. Plenty of companies that would have made it on the East Coast will fail on the West Coast precisely because of the need to hit home runs to the exclusions of singles, doubles and triples.

Chris, I certainly agree that those investors who are heavily focused on metrics and traction are noxious and ill-placed as seed stage investors (they are really Series B, C and D investors). However, I would say that entrepreneurs who combine vision with pragmatism are more attractive to me than entrepreneurs who simply have vision. Might this pragmatism keep the starry-eyed entrepreneur from changing the world, and only building a really large, successful company? Yes. Is this necessarily an indictment on the NY VC reputation of wanting to understand plans for commercialization even in pre-revenue companies? I don't think so.

Thanks for penning this, Chris. You've raised some really important points that warrant discussion.

Roger

These were my $.02. I'd be interested in your thoughts, too.

Advice for CTO Founders: Don't Let Business Kill the Business

Founding a technology company is an amazing thing. I have met dozens of brilliant technologists with fantastic ideas, ideas requiring nurturing, mentoring and support. Too often, however, I have found CTO / Founders paired with business people who not only don't add value, but frequently detract from the value of the business. And from my perspective as an engaged seed stage venture investor, this makes them unfundable. This is not only sad but incredibly frustrating, because it is so easy to see how a great technology can be developed and commercialized if only - if only the CTO hadn't been impulsive and insecure and brought on a business partner too early in the game.

I am a business person, not a technologist. While I know I can add value, I also know when and how I can add value. It is generally a soft touch at the beginning of the development process, perhaps identifying 1-2 early alpha/beta customers to help flesh out use cases to be built upon over time. It is gently laying the foundation for a subsequent financing, helping the CTO set sensible milestones to be achieved that can demonstrate execution skill and release cycle management. It is helping with recruiting by leveraging my networks and experience in a particular domain. And it is most certainly not about me, it is about the CTO, the technology and the company. But I am doing this from the vantage point of an investor / Board member, not an operating executive. Because early in a technology company's life, a true operating executive is NOT what the company needs. In fact, they generally just get in the way.

So why do inexperienced (as entrepreneurs), ultra-skilled CTOs fall into the trap of engaging a business partner too early? Fear? Lack of confidence? Camaraderie? Perhaps all of the above. Many CTOs I know are not that comfortable with the business end of business, directly engaging with customers, speaking with investors and managing business operations. These weaknesses can be addressed in a variety of ways, ranging from engaging part-time, outsourced help to bringing on experienced advisors to help out early in the company's life. These are not revolutionary suggestions, just not necessarily those acted upon by first-time CTO / entrepreneurs. Selecting value-added angel investors and advisors can also help with the camaraderie issue, as they can provide advice and counsel during the solitary period of hard-core coding and product development. A full-time business partner is definitely not required at this point in the company's life.

But sometimes, too often, the CTO falls back on hiring a friend or someone to whom they were introduced that sells them on their value-added. They might give them too much stock, and even have that stock not subject to vesting provisions. And if this business partnership doesn't work out, the CTO / Founder, the engine of value for the company, is stuck in a bad, bad place. Fire the business partner, and the stock they've granted is off the table, stock which is needed to attract and retain talent that can actually help build value and sustainability of the business. Keep the business partner, and the business itself might be rendered unfundable, because quality investors will not put money into a venture with a weak business partner in conflict with the founder. Try to get the founder to negotiate a reasonable exit for the business partner, and this can take years off the founder's life. By the time this point has been reached, the focus has ceased to be the technology and the product, but on organization. And this is one thing that should NOT be the focus of the CTO / Founder during the company's development phase.

So my advice to CTO / Founders? JUST SAY NO TO BUSINESS PARTNERS BEFORE YOU HAVE A REAL PRODUCT THAT IS READY FOR PRIME TIME. And for gosh sakes, spend the time to find the right one. You've spent your entire career working towards this moment. Give it the justice it deserves and don't act impulsively when seeking to address business needs. Your technology brains got you this far; use some of them to make yourself stop, breathe and think. Seek advice from a mentor. Solicit trusted advisors help with interviewing. And if you do feel you've found the right person, by all means make their stock contain standard vesting provisions to guard against a bad fit that takes significant amounts of stock off the cap table.

I don't want to see any more of you with crappy business guys ruining your great ideas, ok?

Are Derivatives the Real Problem?

This piece was published in FT.com earlier today...

Regulators, Congress, and the media generally focus on the crisis at hand. The Enron scandal gave us Sarbox. The market crash has created a PR flurry against “sponsored access” and proprietary trading. AIG generated a firestorm surrounding the use of credit derivatives. The common thread is that policy-makers are reactive and missing the big picture, leading to short-termism and a host of poorly constructed rules and policies. And invariably the word “derivatives” is used as a lightening rod for why new regulations should be promulgated. The problem, however, isn’t exclusive to derivatives; it’s the underlying “business purpose” of transactions. Hedging has a legitimate business purpose. Making markets, speculation, and financing projects have solid business foundations as well. But entering into transactions that serve to hide or obfuscate economic reality work against this principle. And this lack of business purpose is not confined to the derivatives markets, but frequently takes place in the cash markets as well.

Consider leasing, a transaction that has been popular for over 50 years. As the industry has evolved, transactions such as sale/leasebacks and “asset defeasance” have been used to synthetically borrow money without the obligation being reflected as debt on the balance sheet. The form of the transaction: a lease. The substance of the transaction: a borrowing.  The multi-trillion dollar securitization industry has the same motivation: moving assets (and liabilities) off the balance sheet, while economic recourse still exists should asset values and/or debt ratings drop. This is what the market discovered when Citigroup’s multi-billion structured investment vehicles (SIVs) began to fail and the assets and liabilities came back onto its financial statements. What is the proper characterization of a contractually obligated stream of payments? Debt. How should a portfolio of assets and associated liabilities be treated if the risks and rewards of ownership haven’t been completely transferred? As never having left the balance sheet. Yet the accounting profession, with the SEC’s support, has enabled this charade to continue.

Derivatives have also been used to achieve similar ends. Structured transactions have been designed to generate upfront cash without a corresponding obligation being recorded on the financial statements. The recent discovery of Greece’s use of these instruments has shined a light on the dangers of hidden borrowings. Municipalities have mortgaged their futures by selling strips of participations in cash flow generating assets (roads, bridges, airports, etc.) in order to generate liquidity today (at a steep cost to financial solvency tomorrow). The virtually unbounded rise of the credit derivatives industry is partly due to the mismatch between the notional value of derivatives being written and the actual value of underlying instruments. This mismatch can be 5x or more of the bonds being “hedged,” leading to market failures when physical delivery is demanded from counterparties lacking actual ownership (or the ability to borrow the position). Neither of these examples embody true business purpose.

Both cash-market and derivative instruments should be put to the “business purpose” test. Accounting rule-makers, with support of the SEC, should move towards a “principles-based” system where common sense, and not black-and-white rules around which myriad loopholes can be found, should become the new paradigm. But let’s be clear. The issue isn’t derivatives; it’s all financial transactions whose objective is to deceive or to weaken financial transparency.

IA Venture Strategies - Working to Build a Better Venture Mouse-trap

As was ably covered by Dan Primack in PEHub, I am starting a new venture fund. However, as my friends and venture colleagues know, I am extremely down on what the venture industry has become. To be clear, it is less an issue of structure (management + incentive fees in a GP/LP structure) and more an issue of size. It is clear to understand how motivations get skewed when venture firms effectively become asset managers, where the management fees alone are sufficient to make the partners rich and investments must become increasingly large and non-venture like. Growth capital is not venture capital in my parlance. Venture capital means funding "ventures" - taking on early-stage risk - and actively helping companies execute their plans and achieve their potential. I have a theory that the largest a true venture fund can be, which means, having a seed-stage investment charter together with a "life cycle" approach to investing (leaning into winners, deploying larger amounts of capital in Series A and B rounds, if necessary) is around $300 million. But I digress...

I decided to start my fund after determining that many of the deals I was seeing were both strategic and thematic, strategic to my trading company and thematic in that they all had a common thread - helping to manage and extract value from massive, often real-time data sets - "big data" in jargon. Rather than prosecute them as an angel, I felt a fund structure would better enable me to "size up" in particular deals and to cast a wider net across the big data domain. I wanted the fund to be small ($25 million stated goal, but with the ability to go a little higher) and I wanted it to be different than most venture funds I know, who have raised money largely from pension funds and endowments. I really wanted the fund to be an extension of my activities as an angel, where I frequently build syndicates of value-added angels and select venture firms to help de-risk the portfolio companies and create a network effect across a particular domain. This approach has helped me win deals from conventional venture firms that couldn't (or wouldn't) bring such a syndicate to the table and generally had terms that were more oppressive than those I offered (less about valuation, more about participation and specific protective provisions). So how to create a fund that achieved my value-added investor objectives and offered the network effects I was seeking...

My answer was to raise money from "non-traditional" investors, e.g., strategic firms and individuals with knowledge of and deep interest in the big data domain, focusing on verticals with particularly acute data problems. Further, my explicit goal was to bring such strategic LPs to the table as part of a "big data ecosystem" I am creating among my Limited Partners, my venture portfolio companies, my trading company, and leading academics and thinkers in the field. Big data problems are, by their nature, big, and substantially benefit from collaboration across a wide array of domains. For instance, this is why there are several open-source database projects currently in operation, because the problems are growing at such a rapid rate and are so complex that discrete teams are often not best equipped to tackle the issues at hand.

So investor engagement, and not just money, is a ticket to play in this game. Funny thing is, they want engagement. They know that the value of the insights on the edge can impact their operating businesses to a far greater extent than any normal investment they could make. Their early involvement can also help to "de-risk" the portfolio companies, giving them early access to real customers with a strong motive to help out. My trading company also acts as a strategic partner, helping to evaluate the technologies of these big data opportunities and, on occasion, to become an early customer as well. Also, the LPs are excited about the network effects of participating in this ecosystem and sharing ideas with the other members of the community. Finally, they are interested in seeing the filtered deal flow and possibly helping with due diligence, becoming an early beta-tester and even a paying customer. It is really an institutionalized form of what I've been doing for the past five years, except with a unique array of people sitting around the table due to their operating companies and ability to test and deploy the tools, technologies and analytics being developed by the fund's portfolio companies. Neat stuff.

I am also extremely excited to be doing this fund in New York City. I have found NYC to be a great place to base my investing activities and couldn't think of a better place to start my fund. Proximity to Wall Street, big Media, the Pharma industry, several major insurers and health care providers, and a short flight to the Defense complex down in Washington D.C./Virginia. Fertile commercial ground on which to launch a big data fund. I already have three deals for the fund, one in the predictive analytics space (closed), one in database architecture (term sheet) and a NYC-based incubation of a new intrusion detection system. I couldn't be more excited to be working with my early companies and syndicate partners. I am also looking forward to working with those domain-expert angels and venture firms as partners in my portfolio companies. I've always believed in having the right people around the table, and having a venture fund won't change this one bit.

FRC's Exchange Fund: VCs are from Mars, Traders are from Venus

Both the blogosphere and the Twittersphere have been abuzz with First Round Capital's new exchange fund idea. Here are a few extract's from Josh Kopelman's post on the new program: 

This exchange fund was created to allow First Round Capital entrepreneurs to contribute a small piece of the stock they own in their company  -- and share in the upside of all the other companies.

When I was an entrepreneur, I remember the feeling of having all my eggs in one basket -- and it is our hope that this fund will remove some of that stress.  Now our entrepreneurs can get the same diversified portfolio that our limited partners get...

I totally get what what Josh and his partners are trying to do, and think it is both intellectually interesting and proposed with only the best of intentions. But as a practical matter, I just hate the idea.

It might be a cultural issue: I come from a very different world than Josh. He is a (very successful) serial entrepreneur and venture investor. I am a former Wall Street business head who managed groups of extremely aggressive, super high-performing originators and traders who has evolved into a venture investor. Words like "share in the upside" and "diversification" are not words with which I am familiar when it comes to the heads of my teams. In fact, they sound like communist rhetoric to the ears of someone use to the hurly-burly "Pay me for what I do" mantra of Wall Street.

Now, I'm not suggesting that "It's all about me me me" is a good thing. In fact, I think it's a bad thing - to a point. I think the root of my discomfort is with the fact that I want my entrepreneurs laser-focused and all-in, especially as they are working to establish traction and prove out the business model and value proposition. The last thing I want them to have (and I want them to want to have) is diversification. I want them to have the insane confidence my desk heads had, where they wanted to be paid for the value they created in their own businesses, and didn't want to share in the upside of (or, more importantly, have their rewards dragged down by) the performance of other units. Further, I encouraged them to cooperate with other desks and business units when it made sense, but not because I compelled them to do so but because it made long-term economic sense for them to share with others. Forced sharing isn't really sharing. It's coercion. So regardless of whether one has direct economic exposure to the group one is sharing with, the motivations are clear: if it works to benefit my business, I will share. Otherwise, I won't waste my time.

The way I've worked to relieve stress in my entrepreneurs is after they have gotten the business up and running, a scalable model is in place and the growth engine is humming along. At this point I have supported buying a small portion of the entrepreneur's stock, either as part of a financing round or where insiders with deep pockets and demand purchase the stock directly from the entrepreneur. While the amounts involved will not dis-incentivize the entrepreneur from still driving as hard as they always have, they can often be life-changing by reducing stress and really enabling them to focus their energy on the business (even after it is successful). This is my preferred way of handling the "diversification" issue. Until business stability is achieved and rapid growth has taken place, I want the entrepreneur to feel stress - positive and necessary stress, in my opinion. 

Is Josh right or am I right? Reasonable people can disagree. But I am personally fascinated with the idea because it is so completely opposite of the behavior I would want to see in my entrepreneurs.

How I Invest

As part of my year-end reflection and 2010 road map, I have been thinking deeply about how exactly I invest. How do I pick the companies and sectors on which to focus? I quickly realized that the principles I applied in the math of derivatives are the same ones I use as a venture investor. In short, I look at everything as a limit: "What does this (company/sector) look like at infinity?" I see most progress as being asymptotic, e.g., there is a period of accelerated development and rapid growth, beyond which gains are much harder and more costly to achieve. The goal is to find businesses at the early part of the rapid growth phase, but where they are close enough to rapid growth that they don't require decades of funding to get there. For instance, if you had invested in machine learning in the 1960s (or natural language processing in the 1980s) back when it held so much promise, you'd have gone bust many times over waiting for commercial success. Does it mean that machine learning and NLP are unattractive fields? No. But if you were 20-40 years early then I'm sure it seemed that way. My goal as an investor is to avoid such delayed gratification.

While other investors invariably have their own language to describe this exercise, I find calculus to be a helpful tool for testing one's assumptions around a particular investment and for providing valuable discipline to avoid "style drift." Though I make the occasional investment to learn about an interesting business or to work with a particular group of investors, my investing is largely characterized by the discipline noted above.

From a process perspective, this generally means that I have a vision of the future "at infinity" and work backwards to identify potential investment candidates. The key for me is once a candidate is identified, are they close enough to the rapid growth phase and is the market sufficiently ready for this growth to take place? How many times have you heard an entrepreneur say "We were just too early." The road is littered with great ideas whose time had not yet come from a commercial perspective. It is this timing issue where I spend a tremendous amount of time on due diligence, reaching out to industry contacts and testing their receptivity (and willingness to buy) the product/technology in question. Does this approach mean I'll miss some huge ideas that were simply on nobody's radar screen? Sure. But is it a more risk controlled way of reaching for big gains? I think so.

So given this approach, what are some of my "visions for the future?"

1. Machine-driven trading will continue to proliferate, and represent a sustained source of alpha.

If my thesis is right, the most attractive opportunities will exist in the following areas:

• Alternative data. The key question is whether it is more valuable as a distributed vendor product or as a closely-held proprietary product that is traded.

• Modeling platforms. Most platforms today have the ability to ingest structured, quantitative data. Future platforms will be able to consume and model both structured and unstructured data, and to mash up disparate data sources with a limitless number of systematic trading models. They will also provide for straight-through processing, generating trading instructions and executing trades directly from the modeling platform.

• Database architecture. The relational database of today will be inadequate to process the massive amounts of unstructured data - in real time - that tomorrow's (and, in fact, some of today's) trading models require. This also encompasses distributed and high-performance computing.

• Predictive analytics. Extracting insight from large bodies of textual data will challenge current analytical frameworks. New methodologies will arise to meet this challenge. This also includes event notification and anomaly detection, which has relevance for anti-terrorism and anti-fraud applications as well.

2. Tomorrow's ad exchanges will resemble the stock and options markets for equities.

This has implications for liquidity, price discovery and hedging:

• Aggregated buy- and sell-side ad demand. Fragmented exchanges will be be stitched together, leading to a consolidated view of sell-side inventory and buy-side interest. Price efficiency will skyrocket. Buyers will be able to hedge and speculators will be able to take a view on the direction and volatility of context-specific impressions.

• Consolidated buy-side optimization platforms. Agencies and brands will have access to platforms that integrate disparate forms of data and metadata, exchange prices and enable ad campaigns to be optimized and ROIs to be calculated. They will control the structuring, buying and monitoring of online ad programs.

3. Social media will simply be called "media," and viewed as a fully-integrated part of the overall media buy.

Distribution, monetization and ROI measurement will be key drivers of success:

• Apps that aggregate fragmented audiences across Twitter, Facebook and other social media outlets.

• Platforms that facilitate monetization of these fragmented audiences, and deliver a powerful suite of tools for agencies, brands and content owners to use for advertising, promotion and ROI measurement.

• Tools that enable agencies, brands and content owners to carefully control which ads and promotions are displayed to which audiences, placing reputation protection and control in the hands of those with the brand and relationship equity.

These are but three of the themes I am actively pursuing today. Success is by no means assured: I am banking on a vision of the future which may or may not come to pass. But if the focus is on true seed stage investing, then not to take a bold forward-looking approach is dooming one to derivative and "me too" ideas. This is simply not the way I choose to invest. It isn't fun, and in my opinion won't ultimately yield the greatest profits, either.

2009: A Year of Opportunity

2009 entered like a lamb. A tired, wounded lamb. The financial markets were in shambles. Consumer confidence had plummeted. Fear permeated almost every walk of life. Holiday parties a year ago were filled with gallows humor: "Boy, this has been a crappy year. How can things get much worse?" From a public markets standpoint, they did get worse until an abrupt V-turn in April caused both equity and credit markets to soar. Confidence began to creep back into the picture, though the average consumer - as well as the largest venture capitalists - were still feeling a chill from the economic downturn. 2009 is closing on a big up note, with continued strength in the equity markets coupled with some apparent improvement in the labor markets. With rising interest rates in the offing, however, there is still plenty of uncertainty going into 2010 - notwithstanding the historic Wall Street payouts.

From a personal standpoint, I couldn't have imagined how fertile the environment would be for early-stage investment. I personally invested in 12 companies during 2009 across my three areas of focus: financial technology, advertising technology and digital media (only 10 are listed on my IA Capital Partners deal page as two of the companies are in stealth mode). Even more importantly, both my legacy portfolio and my 2009 vintage companies performed well from an operating perspective, notwithstanding the challenging economic environment. Being a small, non-institutional investor with liquidity gave me opportunities to deploy capital at attractive valuations with terrific entrepreneurs without butting heads with larger venture funds. 2009 also saw the rise of the small and nimble venture fund ($15-$40MM), with the ability to write $250-$750K checks and roll up the sleeves to help nascent entrepreneurs succeed. Founder Collective (Domdex, AdSafe Media), Contour Ventures (Ticketfly) and Metamorphic Ventures (OrcaOne) are but three of the VCs in this size range who have been great partners to work with. And while Betaworks isn't technically a fund, I put them into this same camp of hands-on, value-added partner (Bit.ly, TweetDeck, Stocktwits).  I also have had the pleasure to work with some larger venture funds who are willing to invest early in a company's evolution and act like smaller VCs, but with the resources to finance continued growth as circumstances warrant. True Ventures and Foundry Group fall into this category. They have shown me that being larger doesn't mean being impersonal and risk-averse.

While social media might seem over-heated, in many ways it feels as if it is just now coming of age. Buddy Media saw astonishing growth in 2009, fueled by brands' recognition of the importance of social media and the power of ROI-based online campaigns. Ticketfly, which brings state-of-the-art integration of social media and e-commerce to concert venues hit the ground running and is already generating substantial revenues in only its first year. TweetDeck and Bit.ly also witnessed rapid user adoption as Twitter and Facebook continued their inexorable growth, bringing one's real-time presences together in one place and generating valuable data about online trends. TLists has already indexed hundreds of thousands of Twitter Lists, and rendered them easily discoverable through its powerful semantic search technology. It has also brought a suite of powerful List management tools to publishers, including partners such as the Wall Street Journal, The Atlantic and Huffington Post. And Stocktwits has continued in its mission to bring smart, experienced, action-oriented content to its users and partners such as NASDAQ and Bloomberg.

Like social media, advertising technology has seemed like a field with too many ideas chasing too few scale opportunities, but portfolio companies Invite Media and Domdex have carved out important and valuable niches in the spheres of ad optimization and search re-targeting. My positioning in financial technology has been heavily focused on the systematic/quantitative trading community, having backed Selerity (ultra low latency event notification), Alphacet (high-end quantitative modeling with automated order routing) and my home-grown company Kinetic Trading. Each firm is generating revenues and has momentum going into 2010. I believe that start-ups in predictive analytics, high performance computing, database architecture and event detection will be important areas for investment in 2010.

Thanks to all who helped make 2009 a year to remember. I couldn't have dreamed of working with such a great group of entrepreneurs and co-investors at the beginning of what was shaping up to be a dismal year. Notwithstanding the inevitable macroeconomic challenges of 2010, I am confident and early-stage investment will continue to provide attractive opportunities for those with the vision - and the guts - to take advantage.