A Special Opportunity

I don’t write a lot about Kinetic Trading, since my karma boomerang/heavy sharing modus operandi kind of stops when talking about identifying, developing and exploiting sustainable informational advantages. However, I feel compelled to pen something since a pretty cool opportunity has arisen at the company which will be the right fit for a very interesting, creative, high-IQ person. And it is somewhat unique in that the right person will be a mix of technologist, portfolio manager, trader, risk manager, optimization guru and data geek operating in a hybrid tech start-up/trading environment. And they will have a healthy degree of humility when applying their sizable intellectual powers towards taming the markets.

Kinetic Trading has a distinctly different culture than your average quantitative/stat arb hedge fund. It feels more start-uppy and collaborative, and occupies a space and mind-set quite different than the normal quant fund. Different uses of data, different platforms and frameworks, different approaches for extracting alpha at scale. It isn’t simply a squadron of math and physics Ph.Ds. We have those, too. But to be clear, we most assuredly DO NOT suffer what Rick Bookstaber so eloquently wrote about in a recent post discussing “Physics Envy in Finance.”

The markets are not physical systems guided by timeless and universal laws. They are systems based on creating an informational advantage, on gaming, on action and strategic reaction, in a space without well structured rules or defined possibilities. There is feedback to undo whatever is put in place, to neutralize whatever information comes in.

The natural reply of the physicist to this observation is, “Not to worry. I will build a physics-based model that includes feedback. I do that all the time”. The problem is that the feedback in the markets is designed specifically not to fit into a model, to be obscure, stealthy, coming from a direction where no one is looking. That is, the Knightian uncertainty is endogenous. You can’t build in a feedback or reactive model, because you don’t know what to model. And if you do know – by the time you know – the odds are the market has changed. That is the whole point of what makes a trader successful – he can see things in ways most others do not, anticipate in ways others cannot, and then change his behavior when he starts to see others catching on.

The Kinetic Trading team gets the joke. In fact, the ethos of the company is in clear recognition of the  perils of treating the markets like science project.

Kinetic Trading applies the latest technologies (including leveraging open source tools and applications) to systematically generate alpha at scale. The company has a great team, supported by terrific partners and advisers to help prosecute the opportunity. But this specific role is critical in helping Kinetic Trading best monetize its data and IP. Perhaps you’re the right person to make it happen.

You can get a full description of what Kinetic Trading is looking for and apply for the position here: http://bit.ly/KineticPMT.

Can Micro VC Go the Distance?

My friend Fred recently authored a post titled The Expanding Birthrate of Web Startups, raising an issue that weighs on my mind daily: how to support seed stage investments throughout the investment life cycle. Here is an extract from his provocative and insightful piece:

The VCs I talk to who have been doing this for 25 years or longer aren’t so much worried about the “dipshit companies” (as if there were such a thing). They are worried about the entry of so many new investors with relatively small funds birthing so many companies. These veterans may not be as connected to the latest web startup, but they sure are connected to the realities of the venture capital business. They’ve lived through it and they know what is involved with getting a company all the way to profitability and exit.

The venture capital business is contracting. There are less VC funds than there were a few years ago. And there will be fewer in a few more years. And the birthrate of web startups is expanding. That is the challenge we all face.

So, if you are an entrepreneur you should be very focused on either getting to profitability or getting a VC firm or two with deep pockets into your company (or both). If you are a seed investor, don’t go quite so fast. Reserve some funds for follow on investments. And help your portfolio companies get to profitability or get a VC firm or two with deep pockets into your company.

I think this expanding birthrate is a great thing. Entrepreneurship is alive and well all around the world. Smart and scrappy entrepreneurs are imaging new products and services and building them. But we all should be careful to think about how we are going to fund all of this company creation. Not just the first part of it, but all of it.

One of the biggest issues I have as a small venture fund is how to reserve for follow-on investments. While some have strategies of making extremely large numbers of small investments and following on in none or very few, IA Ventures’ strategy is a much more traditional “lean hard into winners” approach (albeit with extreme domain focus); the dollars required to validate the technology and business model are (relatively) small, leading to quick and informed decisions concerning follow-on investment. When our capital and participation has helped de-risk a business to the point where it is appropriate to follow on and finance growth, we want to step up to do our pro rata and beyond. This makes the reserve policy question extremely important, especially when the resources at our disposal are small compared to a larger funds with whom I work every day such as True, First Round and Flybridge. In short, we can’t do it alone. And pure angel syndicates often suffer from a lack of leadership, which isn’t a problem until there is a problem. Who will step up and take the lead if the company needs more time to hit key milestones? It’s not merely an issue of deep pockets but of leadership, structure and experience. Fred articulated a concern that has been bubbling around in my mind, and I penned the following comment to his post:

fred, you’ve clearly raised a very powerful and important issue. mark (suster) and josh’s (stylman) comments both strongly resonate with me. to me the issue is one of the seed funding business model.

as mark accurately stated, there is a lot of (traditional) vc-bashing going on. while some of it is warranted, some of it is not. my fund, ia ventures, regularly partners with larger funds on seed deals, fears about signaling aside. i personally feel the signaling issue of larger funds investing in seed deals to be overblown, as in my experience high-quality firms make high-quality decisions that generally reflect the risks and rewards of the company.

while running a seed fund, we are focused on appropriate reserves to be able to follow on, but clearly acknowledge that other syndicate members (with deeper pockets) will need to participate if an inside round to buy more time is warranted. many other seed funds have chosen to invest small amounts in many deals and to avoid reserving for follow-ons. this is certainly one person’s valid business model but it isn’t mine. what happens to those syndicates where there aren’t deep-pocked funding sources at the table (and more time is needed for the company to hit key milestones) is a worry to me as well. angel syndicates are great and can add lots of value. i spent the better part of six years leading and participating in such syndicates. but as i’ve matured as a seed stage investor i’ve come to embrace larger fund partners as a constructive way of helping to address the follow-on/bridge problem as well as having another smart and engage set of partners as part of the syndicate.

i’ve written about ia ventures’ asset allocation model, and believe it to be a right and valid approach, at least for me. 20-25 deals, a mix of incubation, smaller “opportunistic” positions and larger “concentrated” (more classic VC-type) positions. this likely requires $20mm or so to minimally prosecute properly. however, additional value can be created by moving from $20-$40mm. would this money go into new deals? no - it would simply represent additional reserves from which to follow on. i firmly believe that the life cycle approach to investing is the right approach to maximize ROI, build strong and lasting entrepreneur relationships and to be “in the market” at the time maximum value is being created. but after so much de-risking has been done at the seed stage of the deal, wouldn’t it be great to have additional reserves to lean heavily into winners and to increase stakes when opportunities present themselves? indeed it would.

So to answer the question: Can Micro VC Go the Distance? Yes, but not by itself. It needs larger partners to help support growth further along the investment life cycle. It doesn’t need to be a we/they relationship between Micro VCs and larger VCs. It can, and should, be a collaborative and mutually beneficial relationship that ultimately inures to the benefit of the entrepreneur and the company. And that’s kind of the whole point.

In Search of Corporation 2.0

So much time is spent talking about start-ups, early product/market fit and fund-raising that one important point seems to get the short shrift: managing - and anticipating - the transition from rapid growth to maturity. In essence, a billion-dollar problem with billion-dollar consequences. Vivek Wadhwa recently penned an insightful post from the policy perspective as to why small ventures, and not big businesses, should be the beneficiary of favorable investment and tax treatment. Managing a flattening growth curve in its core business is an issue that has confronted Microsoft for the better part of a decade, and which is just now starting to weigh on Google. It gets at issues such as creative destruction, capital structure, dividend policy, culture and core competencies. The period from rapid growth to maturity is becoming ever-more compressed as competitive advantages are simply not sustainable in an innovation-driven, technologically-enabled world. Open source software and cheap hardware has substantially lowered barriers to entry, and monopoly profits are aggressively attacked by new entrants in virtually real-time. This will become an increasingly hot topic as the darlings of yesterday begin to lose their luster, and the discipline meted out by the public markets will begin to shape the decision-making of corporate leadership. A much more flexible governance paradigm will be required to effectively manage Corporation 2.0, and some old - and destructive - habits will have to fall by the wayside if the next-generation corporation is going to maximize shareholder value not just for today but over the long haul.

Microsoft’s long and twisted road is a cautionary tale from the past. Over the course of a generation we’ve seen Microsoft come out of nowhere to become arguably the most powerful corporate enterprise on the planet, only to stumble badly, straying catastrophically from its core mission and burning $100 billion+ of shareholder value. As growth in its core enterprise OS business began to flag, it aggressively sought to both diversify its bets and to create entire new business lines that were not at all related to what made it successful in the first place. But let’s be clear: flagging growth does not mean growth approaching zero, it means when the rate of growth has begun to sharply drop off, when the “denominator effect” of a very large and successful franchise has made historical levels of high double-digit and triple digit year-on-year growth a mathematical impossibility. So when growth in its core franchise began to flag and when a rapidly changing information transmission landscape - wireline, wireless and broadband - sowed the seeds of fear in senior management, Microsoft went on a historic diversification program. It made a series of minority, billion-dollar investments in businesses such as AT&T, Comcast and Nextel. It then went into the consumer hardware business, championing devices such as the Zune and the Xbox, plowing tens of billions of dollars into its Home & Entertainment business. It also sought to use its monopoly power in its OS business as a strategic weapon in building its Internet franchise, creating years of litigation and management distraction as challenges in the US and European courts played out. And over the past decade Microsoft’s equity market value has dropped from around $500 billion to $200 billion in nominal terms. It has unquestionably been a tough period for the vaunted Microsoft.

So why the problems? How could Microsoft have seemingly blown what looked to be such an unbeatable hand? Here are a few hypotheses:

• Style drift. Microsoft displayed extreme prowess at selling packaged software for the enterprise. They then tried their hand in an array of unrelated fields: hardware, consumer products, “strategic” investing, etc. Success at software simply hasn’t translated.

• Excess financial resources. Enterprise software became akin to a gushing oil well. They discovered it, capped it, extracted (and continue to extract) value from it, and the margins from extraction are extreme. The problem is that it is a depleting asset, akin to the AOL dial-up service (except on a much greater and more profitable scale). Plentiful cash from this depleting asset was diverted from shareholders or growth projects in related businesses into those largely orthogonal to its core business. Result: strategic and financial disaster.

• Management meglomania. Admitting mistakes has not been one of Microsoft management’s strong suits. Is it just me or does it seem that the window-to-the-livingroom strategy built around the Xbox360 has become a win-at-all-costs death match? No business should have this character; execution should be rational and based on the prospect for profits by driving value to end-users. The “We’re in it to win it” and “We’ll spend what it take to make it successful” protestations of Steve Ballmer sound confident, passionate and completely horrifying to a Microsoft shareholder.

• Lack of comfort with the monetization stage of the business. Sick amounts of oligopoly profits have not been enough for Microsoft management. They want to continue selling themselves as a (rapid) growth company. Merely harvesting and distributing profits is seemingly a sign of defeat: making far-off bets on growth using shareholder resources appears to fit better with their DNA. Problem is, shareholders can neither eat ego nor will they wait around for large lottery-ticket type bets to pay off.

There have also been massive changes to the technology and innovation landscapes over the past 25 years that make Microsoft somewhat of an anachronism. A few of these changes include:

• The rise of Open Source as a vehicle for constantly improving core technologies (separate from the commercialization, support and customization of these technologies).

• The emergence of Cloud Computing as a vehicle for accessing cheap processing power and storage, tilting the balance of innovation from large, well-funded but bureaucratic incumbents to smaller, nimbler start-ups.

• The creation of a global technology labor pool where virtually any kind of development project can be built both well and at relatively low cost.

• The willingness of large enterprises to test new products and services from early-stage companies, acknowledging that reliance on large legacy providers is not enough for them to maintain their competitive edge.

So what does this all mean for Corporation 2.0, an enterprise that, while large, remains flexible, innovative, and continues to create value for customers and shareholders throughout its life cycle? With the radical transformation of the technology landscape, I do not believe that there are many valid oligopolies left. Microsoft, Oracle, SAP… their rise to power took billions of dollars of investment and created enormous barriers to entry when the world was dependent upon proprietary software. Scale benefits did exist in the creation and maintenance of these large software packages. Once installed, with the painful integration required, there were huge (and generally unacceptable) costs of switching. In today’s world, barriers to effectively competing with these behemoths are getting smaller every day. Similar barriers are crumbling on the hardware side of the equation, with virtual storage and access to flexible processing power. The winners of Corporation 1.0 may necessarily give way to a whole new set of entrants based on shorter, more iterative development cycles, cheaper, less costly infrastructure and distributed development environments.

I think the issues necessary to succeed in the Corporation 2.0 world break down into two separate but related buckets - strategy and financial. Here are some initial thoughts:

I. Strategy 2.0

• Be constantly in a phase of creative destruction. The highest-profile example of this is Netflix. They started a business knowing that it would become marginalized in the relatively near future, made it successful, extracted profits, and plowed those profits back into a business that directly competed with its golden goose. Crazy? Not if the focus is on creating long-term value for both customers and shareholders. They are now running head-long into streaming video, which sets them up for tomorrow’s environment while harvesting gains from today’s mail-order DVD rental business. Could you imagine if Microsoft had both anticipated the rise of cloud computing and shared applications and offered it commercially? Would it be selling less software? Probably. Might its short-run profits suffer? Yes. Would it be better positioned for the future? Undoubtedly. Like so many businesses that made the shift from enterprise sales to SaaS; expensive in the short run but vastly more profitable and sustainable in the long run.

• Know your core competencies and avoid style drift at all costs. Software development? Marketing and distribution? Predictive analytics? Whatever it is, entering into businesses that are largely unrelated to the core is a recipe for disaster. This is not new news; it has been happening since the dawn of time. But companies keep making the same mistakes. Microsoft is simply among the most visible examples due to its scale and profile, and the magnitude of the dollars that have been spent ostensibly in the name of “building shareholder value.” Ha.

II. Financial 2.0

• Don’t be afraid to harvest and pay out profits. Managements are so afraid of losing their growth stock luster that they will often enter into ill-conceived diversification projects and M&A transactions to please the Wall Street analyst and investor communities. Every constituency is hurt by these steps but one - company management. If a business is maturing, vastly profitable and perhaps not in need of much incremental investment, the by all means dividend cash out to shareholders. Too much cash burning a hole in the corporate pocket can only lead to bad outcomes. To be clear, this is separate from an amount of cash reserves to handle variability in the economic and competitive environments.

• Segregate cash cows from rapid growth businesses. Let’s say that a company’s core competencies has led it to build a very profitable cash cow (like Microsoft’s Enterprise Software business) but also lends it to a series of high-growth investment opportunities in related areas. The cultures and compensation regimes of these business lines should be different. The businesses should be financed differently. Management of these businesses require different skill sets. Corporation 2.0 will need to be much more flexible than Corporation 1.0, able to seamlessly make the jump from rapid growth to mature businesses and back again.

• Take the long view. The quest for short-run profits has and will always be a fool’s errand. Notwithstanding the compression of product and technology cycles, it is more important than ever to eschew investor pressure and to manage the business for maximum long-term profits. This means on optimally managing the cash cows, internally financing strategically important and relevant high-growth projects while paying out excess amounts to shareholders. Investors may complain that paying out cash means the company is no longer a growth company and penalize the P/E ratio over the short run, but operating success will ultimately provide vindication and recognition in the marketplace. Warren Buffett may be many things, but one thing he is is true to his mission and deeply knowledgeable of Berkshire Hathaway’s core competencies. Corporation 2.0 should aspire to such discipline and perspective.

None of these changes are easy, but are much easier if they are built into the fiber of a company from the outset. Most Corporation 1.0 leaders are likely beyond hope. Their cultures will make them unable to adapt, they will suffer a loss of key talent and radical re-positioning of multi-billion enterprises employing thousands of people is painful, complex and generally unsuccessful. Young companies born and bred on open source, cloud computing and flexible and iterative development environments have a rare opportunity to position themselves for generational success. But it will require a lot of planning, tremendous guts and laser focus on avoiding conventional wisdom as espoused by Wall Street. I am excited to see who is up to the challenge.