Over the past week we have seen a ton of the “will they, won’t they” reports on Groupon and its potential nuptials to Google.

Rumors of price have been as high as $6B for the company – a price so high that most assumed that it would be irresistible to turn down – and yet Google has seemingly been left at the alter by a runaway bride – who, as it turns out had a larger dowry than expected (courtesy of about $135M of secondary stock sales.)

So is Groupon and its investors crazy to turn down this sort of money?

I don’t think so.

Here’s why:

It is rumored that Groupon has about $1B in revenue. Now there model is simplicity itself. They pay out 50% of that to their partners who offer the discounts – and the remainder of the company cost is in sales. If you look at a typical media company at scale – they tend to run about 20% of sales as costs (incremental margins on the extra $ of revenue is over 80% often) – so on $1B of revenue you have $200M of costs. Since most of the Groupon employees are either sellers or administrative people writing copy for the deals and there is not a ton of hard technology nor is there a ton of database necessities or server needs – one can assume that the cost structure is not going to get too far beyond the SGA line.

My guess is that Groupon is doing $1B in revenue – $500M in Cost of Good Sold, $200M in SGA and perhaps another $50M in miscellaneous costs (real estate – exec salaries, the cost of ramping up ahead of revenue etc…) – for a total of $250M in EBITDA.

So Google offers $6B for $250M in EBITDA – 24X which seems like a large number – but if EBITDA is scalable and growing extremely fast (over 100% per year right now) – then the 24X becomes 12X in a year and 6X in 2 years – which seems like a pretty good deal for Google – and is probably one of the reasons why Groupon decided to remain private.

So is Groupon Crazy? I don’t think so.

Now in order to reach that conclusion, you also have to believe that Groupon will continue to take an increasing share of the local advertising market – particularly the promotional budgets and marketing budgets of the local advertisers.

It has been written that Groupon has cracked the local problem – and that all of the $100B per year or more that is spent locally is open to them. Perhaps, but I think it is instructive to disaggregate that market a little bit and see just who is using Groupon.

As a store owner – if I choose to use Groupon, I am offering a 50% discount generally – and Groupon is taking 50% of the offer price – so in essence, my net is 25% of the retail price. The question is, who can afford to offer 75% off on a regular basis?

The answer falls into two buckets:

1. Companies with extremely fixed costs, high marginal profit levels, perishable inventory and incremental capacity. Say you own a spa. The overhead is completely fixed and you are paying the workers to be there – so incremental margins are high. You can imagine that the margins on cupcakes are very high. If you own a school or provide a service where you already have staff being paid for who are sitting around part of the day. I live in Fairfield County – and today’s deal is $10 for $20 of Michelle’s Pies. Now Michelle makes some fantastic pies – my family had an apple crumb pie last night from there – so I can attest to the quality, but this is a perfect example of an ideal Groupon deal. Baked goods have tremendously high margins – it is a volume buiness. Michelle has a storefront (paid for), bakers on staff (salaried employees), very high margins (cost of goods on a $20 pie can’t be more than $3), a perishable inventory (how long is that pie going to keep before you have to replace it?), and slack capacity (when’s the last time you went to the baker only to find all the pies sold out?)

2. Companies looking to lose money in order to convert customers into regular paying customers. Businesses willing to spend money to acquire users. In most media businesses this is called SAC (subscriber acquisition costs) or CPGA (cost per gross add). The issue with these costs are that you have to know very well what the lifetime value of the customer is in order to price these properly. If I go to a store on a Groupon deal and never return – it was a terrible idea for the store to offer me the discount. If my regulars use the coupon, it is also a terrible idea. My guess is that most local businesses couldn’t even begin to think about understanding the concept of lifetime value at the customer level.

Now let’s look at the local advertising market. If you take a look at the revenues of typical local advertisers it consists of car dealers, chain restaurants, bars and grills, retail stores, electronics chains, supermarkets, etc… What you realize looking at the list is that most of these businesses operate in extremely competitive environments with margins that are razor thin at best. Car dealers are in no position to use Groupon – nor are clothing stores, electronics chains, supermarkets etc… The margins for these businesses are too low – and they already spend a lot of marketing dollars branding themselves. You think Best Buy is really going to offer 75% off some product to drive traffic? Which coimputer savvy shopper has never heard of Best Buy – or hasn’t shopped there recently? There’s just no reason for them to become customers.

And that’s why I don’t think Groupon has solved local. Because it’s appeal is to a small subset of local businesses.

Now that is still an enormous and wonderful business and I’m in awe of the job they have done building the business – but it doesn’t obviate the need for local marketing the way that Craigslist obviated the need for newspaper classifieds. And it isn’t necessarily useful to everyone.

Whether it develops a nation of coupon clippers who only show up for deals and never shop full retail is yet another question – and one that is beyond my scope – but if those cupcake offers drove a ton of business the first time around – I hope that the bakers were smart enough to track the buyers and see if they became repeat customers – or just deal junkies looking for their next cheap sugar high.

Posted by: hdemott | September 15, 2010

Why Cable Is Out Of Touch With Reality

I got this headline from a friend of mine this morning

Charter Starts Itemizing Retrans Bucks In Taxes/Fees Portion Of Cable Bills

The full article is here

This is a complete asshat move by a company out of touch with its consumers.

Nobody likes higher rates: not consumers, and certainly not middlemen – and the cable companies are middlemen pure and simple. They are necessary middlemen, but make no mistake about it – they produce nothing with their cable plant and they have competitors – so they could be disintermediated.

Television networks have traditionally been free to those getting their signals with rabbit ears – and the cable networks have passed along their signals without compensating the networks. Recently, as the proliferation of cable channels has abated, the networks and local broadcasters have started asking the cable channels to provide compensation for the programming that drives the majority of the viewing on the system – particularly when some cable systems (most notably the satellite companies) have been charging directly for these signals.

The cable companies, who see programming expenses eating up between 30% and 40% of their video revenue, have pushed back hard – but can’t really win the fight – as consumers care only about the programming – and not the cable providers margins.

By starting to itemize these retrans fees, Charter is heading down a slippery slope – opening itself up to questions it doesn’t want to answer.

For example – if you are making 40% margins on your video business, why, as a consumer, should I be supportive of your fight against the networks? Are you entitled to a 40% margin by divine right? Why shouldn’t you have much lower margins like everyone else in the world – and make up the difference in lower prices to me?

If you are going to itemize, why not go the whole distance – and start showing line item by line item what you pay for each and every channel on the dial. Maybe people don’t know that they are paying over $4 per month to have ESPN. Or almost $1 per month for TBS, TNT and Fox News. In fact, as a consumer, you are paying a lot per month for programming you have no interest in watching.

Everyone argues that ala carte pricing in cable would be a disaster for programming diversity – and it might – but why should I have to subsidize any programming I don’t want to watch. Particularly in these days of IP Video (think Hulu, YouTube, TV.com etc…) – programming can find a niche audience anywhere, anytime. Perhaps people are just worried that most of the programming is not what people want to watch.

Cable could go even further and explain why they make 85% margins on broadband – amazing considering that the US broadband product is generally considered far inferior to most of the rest of the world.

Or they can explain the 95% margins on VOIP telephony.

Charter can demonize the networks all they want – but at their best networks make something like a 20% margin  – and never consistently – as shows go in and out of favor. CBS, which is pretty much the best network in the US and has been for a while will likely make an 11.5% margin this year (including syndication of its hit shows). Of course a lot of retrans $’s go to the station group – so if I include this number in the total – the margin rises to 17.5% including high margin radio stations (they are grouped together) and about 15% without these.

In my opinion, Charter should keep its bills simple – instead of opening itself up to questions that it doesn’t want to answer.

Posted by: hdemott | September 14, 2010

Living In A Dickensian World

It was the best of times

It was the worst of times

That pretty much sums up the venture world these days.

Under the “best of times” category I would include the following:

  1. Costs of start-ups has gone down dramatically
  2. Large Angel / super-angel community has sprung up to finance good ideas
  3. There’s still a ton of traditional VC money sitting on the sidelines
  4. More and more entrepreneurs are springing from the woodwork
  5. Market is very accepting of new concepts
  6. Traditional media business is being taken apart piece by piece
  7. As a result, many old line media companies are more willing to strike deals with start-ups

Now all that said, newtons law of motion (for every action there is an equal and opposite reaction) certainly holds – and I would put the following in the “Worst of Times” category:

  1. Costs of start-ups have gone down dramatically. Which means that when you come up with your killer idea and get it in the marketplace – as soon as it is seen to have any traction – there will be 5 clones of it within 2 weeks – each tasking a slightly different viewpoint on your solution. there is no “moat” around ideas anymore in the lean start-up world – and it is a sprint, which lasts forever.
  2. More and more angels are financing deals. Great, right? Well yes and no. With more and more angels out there all chasing good deals, they tend to make many more investments at a lower $ price than do traditional VC’s. Which means that you get investors – but you don’t necessarily get as much investor time and help. Pretty simple math – if a traditional VC might have 10 investments, you get 1/10 of his or her investment time (outside of doing all the other stuff like fund raising, looking for new investments, breakfast at Bucks etc…) Take Dave McClure who just closed on 50 different investments in the first half of the year. Great that they got funded, but Dave is a pretty busy guy if you need hands on help.
  3. VC money is still on the sidelines. Yeah this is great – but they either have to get a lot pickier (let’s face it there haven’t been a lot of exits in the past 10 years – and fund returns are generally negative) or go the opposite way and become super duper angels – with tons of $500K investments. If they get more picky – then you don’t get the investment. If they throw spaghetti on the wall – they are worse than the angel folks – at least they are generally operating people who have had success.
  4. More people starting companies means more competition. More competition for good people at your company, more competition for investment $’s, more competition for marketing to get your product to the masses. It is harder and harder to break through.
  5. The market may be more and more accepting of new concepts, but it is also far more critical of them – and with more and more iterations coming out daily – it is increasingly hard to get people to pay attention to your concept for any length of time.
  6. While traditional media guys are more willing to deal – they now realize the threat to their business – and so deals are being struck from a far different position than they used to be. For a long time, media companies generally ignored the threat of the new – and now that they have been forced to not only accept the threat but embrace it – they are still using their position as gatekeepers to hamper growth. Everyone has something to defend.
  7. Have I mentioned that there have been few exits. The successes have been well documented, but I would argue that the rate of failure has probably increased.

So in this Dickensian world – what’s going to be the keys to success – probably the same things as always, great product, great team, great execution. What probably will help going forward will be to grab investors who can actually help you – not just generate a headline. That means help with the business – in biz dev, in marketing, in publicity – with key board members. Not only that – but make sure you can get your product heard above the noise of the thousands of other sites or iPhone apps. Ask yourself what is going to make yourself stand out – then it might jsut be the best of times.

Posted by: hdemott | September 2, 2010

Apple TV – Why Much Of The Blogosphere Has Got It Wrong

It was no great secret – and much of the info was out there already – but when Steve Jobs unveiled the new Apple TV yesterday – much of the blogosphere lit up decrying it as not so interesting  – and a minor update to the “hobby” that has been around since 2006.

Venture Beat downplayed it here and Forrester analyst James McQuivey was less than excited here.

There were others out there – all of whom focused on the same two things:

1. The new Apple TV was launching with less than all the networks content and

2. There is no huge support for open source architecture allowing services like Boxee to run on the the new box

While both of these issues might put off some people you have to remember that  Apple is a very large company selling to the mainstream across the world. By bundling Netflix in with the Apple Store at $99 – you make the device worthwhile for the vast number of iPod, iPhone and iPad owners who want to stream content from their handheld devices to the TV easily. Sure, many TV’s are now equipped with widgets giving you access to Netflix, Pandora and other services, and so the new Apple TV is, in reality, just catching up to my TV – but the excellent UI that Apple provides across all of its devices more than makes up for this. I’d much rather go through Apple’s menu system than Sony’s, or Pioneer’s or Samsung’s – heck I’m already using it on all sorts of other devices – so it feels native to me.

As for the the lack of Boxee support or other video support from the web, I’m solidly with Steve Jobs on this one. When I turn on the TV, I want professional content not squirrels surfing (BTW: the Apple TV does support You Tube – so if I want the surfing squirrel, I can see him – although I can assure you he will look like crap on my 50 inch plasma display). More importantly, the one thing I would like to use my 50 inch plasma display for is pictures – and that will be handled well.

Sure 2 of the networks and some of the cable channels are missing from the line-up on day 1 – but is that a real deterrent. As someone wrote yesterday, this device is not meant to replace cable (yet) – it is an input 2 device – and so I am more than happy to watch Dexter on my DVR if CBS decides not to participate in any way into the future. But guess what – all content guys go where the audience is – and if Apple ultimately sells a lot of Apple TV boxes – the content guys will be there ready to sell $0.99 downloads of their latest TV show. Remember, the average prime time television series costs between $1M and $2M to produce. Imagine a world where Apple sells 10M Apple TV boxes (maybe aggressive – but sooner or later?) If the networks could start defraying a good bit of their production costs through the rental of these shows – to a small population of real fans – the economics of the business start to work in their favor – and that is what will drive the move ultimately to these type of services.

The blogosphere is in love with Google TV – they want a television OS – and they want to cut the cord on cable’s video service (they never seem to write about where they are going to get their massive bandwidth to run all the video they want in HD to their TV sets – but that’s another post). Apple TV does nothing to further that ambition – and Apple is correct to pursue this path. Ultimately they are a consumer facing company – taking technology and making it available to the masses. Google is in the other camp – they are an engineering facing company – taking technology and asking the masses to come to it. Their big product – search – was and is like an apple product – clean and simple – doing a massive amount of work in the background and returning massively useful information in under a second. Contrast that to g-mails contact program – which only a Google engineer with a 160 IQ could love.

In front of a computer, I might put up with the Google view of the world – but on my TV, kicking back in my lounge chair – give me the Apple device.

Over the last 24 hours I’ve read no less than 5 VC luminaries discuss the finer points of Convertible Notes versus  Convertible Preferred Equity.

Fred Wilson is here

Chris Dixon is here

Brad Burnham is here

Seth Levine is here

Mark Suster is here

My answer to the debate is:


The debate misses the essential points.

All of these articles rehash the finer points of the deal structures and the pros and cons of each – but to sum it up – convertible notes (particularly the ones with no caps) are for either unsophisticated investors or professional investors who are desperate to be in a specific seed stage deal. Otherwise, traditional preferred structures are the way to go – as they give you the equity rights you demand for taking equity risk and properly price the deal (why else is a fiduciary giving you money for – to abdicate this duty?)

Okay, so what is the real point behind all of these conversations?

The point is that the VC market has moved from having too much money chasing too few deals in the early to late stages – to having too much money chasing deals at the seed stage.

The outcome of this is that valuations are rising – and terms (thus the debate between convertibles and preferred) for professional investors are getting worse.

For a real VC, not an angel or super angel with $20M to invest, particularly a VC with a “name brand” this is a particularly dangerous position to be in. With enough $ chasing early stage deals – and convertible debt getting more popular, VC’s will be forced into a choice of  putting money into structures that are not particularly favorable for them or trying to convince founders to change the structure to an equity position.

The great thing about being a “name brand” investor is that you can get in early, and then get a ride on the valuation as your involvement helps push up valuation to the next round. If the company is really doing well, there are still a host of late round investors who are willing to buy secondary shares – so you could end up in a position to sell a small minority of your shares and get all of your capital back – while continuing to keep all of the upside.

If you agree to a convertible structure – particularly one without a cap – you are working against yourself. A “name brand” VC will push up the next rounds price – and thus they will own less of the company without a cap – and if they are going to have a cap – then they are setting the economics – so why not just go to equity anyway – it is what they are doing.

The flip side of the coin is not really examined either.

For founders, convertibles without a cap are fine – and Brad Burnham explains this in some detail – so I won’t rehash it – but they too are missing the bigger picture in all of this debate.

When doing a seed financing, you partners are really all that matters – outside an obviously mispriced valuation (Chris Dixon makes this point well). So when founders demand convertible notes with or without caps because of legal fees or because they feel it is going to give them an extra 2% ownership in the company – it is a rookie mistake – shortsighted and ultimately potentially destructive.

You don’t create value on a seed stage deal – but you can set up a situation that makes it more difficult to fund later.

There has been a ton written about the negative signaling effects of a “name” VC who doesn’t follow on – but not much written about why this happens. Lost in this structuring debate is an important point for founders which is the following:

1. Pick your financial partners not by what price they are offering you or what structure they are proposing – but based on what they can do for you beyond handing you the check. 1 second after that wire has hit – their money is no different than anybody elses – and you are now stuck with them. Is that a situation you want?

2. Forgetting domain expertise or a VC’s ability to get you in doors with partners or buyers – ask yourself whether your new partners are people who you are willing to spend a day a month with – and speak regularly to – and talk and e-mail even more frequently. Because you will.

Just an uninformed opinion, but if you are going to take money from a “name brand” VC – do it in a way that makes the greatest use of their brand name – so it in the form of a simple preferred doc – and get busy building value by executing on your plan. However, only take money from anyone, brand name or not, if you feel strongly that you have some personal chemistry with and who offers you more than a check.

My guess is that when “brand name” investors beg off after an initial seed round they do it for one of two reasons: 1. either the team and company is not performing well, in which case the signal is real and future investors are potentially smart to stay away, or 2. the investment was just money, and there was never any real personal involvement between the founders and the investor and never was going to be. Of course it could be both – but you usually don’t see people walk away if things are going well and everyone is getting along and working together toward a common goal.

P.S. While trolling around I just ran across a piece that makes this point perfectly. David Pakman of Venrock has a great post up. Read it here

Posted by: hdemott | June 14, 2010

Digital Filling Stations

Starbucks announced this morning that they would be offering free wi-fi at all of their locations starting July 1st.

See coverage here

How long will it be before they start billing themselves as the digital filling station?

As I wrote earlier this morning – with metered pricing now a reality on AT&T – we will see some real high bills from some people who don’t realize just how much data is used streaming a Netflix movie.

A big winner will be companies that can stream with efficiency – or apps that are more self contained and don’t need to go out to the web.

Another winner might just be media companies who allow for caching on devices. Music companies only get paid when songs are played – yet caching is generally not allowed under the free services like Pandora. With these new rules in place – it might make sense to revisit this. Same with Netflix. Studios want their movies played – because that is how they get paid. Hulu wants videos watched (as does YouTube)  – because the greater the viewing – the more commercials get run. Yet if it is going to cost you another $25 per month to watch an ABC video – are you really going to do it?

I predict a real renewed level of discussions around the idea of caching

And I expect there to be more and more digital filling stations out there on the information super highway.

Posted by: hdemott | June 14, 2010

The Efficiency Premium

If you live in the traditional media world – one of your main attributes and advantages are a lack of efficiency.

HD video is beautiful – but takes a lot of bandwidth.

Radio broadcasts on the FM band sound fantastic  – but are uncompressed and take up multiples of the bandwidth used by Satellite Radio or Pandora.

Books are an exercise in a lack of efficiency – killing trees by the score to get the message out.

So how does this play in the new media world?

Not so well.

With A T & T having a virtual monopoly on all things Apple – and with the all you can eat data buffet coming to a close – it is going to get increasingly expensive to consume data on the go.

According to a recent Sanford Bernstein report, watching a Netflix movie on your iPad will use up your data allocation in about 41 minutes (assuming you use the iPad for no other data). Throw on a few hours of Pandora – a ton of web browsing – e-mails, etc… and you are looking at a very large data bill unless you spend a lot of time in wi-fi hotspots.

Given that, do you want AOL IM pushing you messages? Do you want facebook sending you e-mails? Who wants to download large attachments?

The obvious answer to me is that you want to look at companies that offer efficiency.

Who can do the best job of compressing audio and video files? Which systems to the best job of caching? Which applications are simply the least data intensive? Who offers some sort of variability in how I use a mobile device depending on just how much data I have left under my plan?

All of these factors will come to the fore in the not too distant future.

The relentless march of richer and richer websites will be met with higher and higher user bills – which will ultimately result in lower and lower usage for those applications that are spending your money the fastest.

Seems like there will be a real premium on efficiency coming up – or put another way – it seems like with the proliferation of distribution points – there will need to be a wide variety of different formats that are optimized for the platform itself. So for movies – if I am watching on a 60 inch plasma display – I want 1080p. If I watch the same movie on my iPhone, not only do I not want 1080p (it doesn’t have the resolution) but I may want a differing quality level depending on whether I  have the movie cached or it is streamed – and I may want a different level of quality depending on whether it is streamed over wi-fi or over a 3G or 4G network.

It’s a lot of variables.

Companies that figure out how to easily optimize for all of these variables should do okay.

Posted by: hdemott | June 12, 2010

The Value Of Information – I Am My Own Editor

With the whole Facebook privacy kerfuffle still fresh in peoples minds (see this back and forth between Techcrunch and Jason Calicanis on the subject), I read a great post this morning from Brad Burnham of Union Square Ventures – who talked about platforms as governments. The question is, what sort of government is Craigslist, Facebook, Apple, Google, etc….

As usual, some of the best ideas came in the comment section

What really struck me was the large number of comments I read this morning – as well as other days on just who owns the infomation on these services.

Do you own your own info when you post it up there? Can you take it with you?

As I said on Fred Wilson’s blog this morning:

I’ve never really gotten the idea of people expecting the data they provide to be theirs exclusively. If you want exclusivity – don’t post it online – and then see if there is real value for you insights and personal lifestream. Unless you can get reality show contract – my guess is that the internet has taken data that has heretofore had little value – and by aggregating it and distributing it to the people for whom it does have some meaning – has created a ton of value. Whether some of that value is captured by the platforms is almost irrelevant to my way of thinking – I am providing value – and am receiving value – and I can opt out at any time. A pretty fair trade in my opinion.

This got me thinking more about the value of information.

There really is no value to my comments or posts without an audience of people who may or may not find them interesting. Pictures of my kids are useless to anybody but my friends and family. Where I ate breakfast is generally of little import to anybody, but by posting it up via Foursquare – it might reach a few folks to whom it does resonate.

When you think about it, the internet has taken information and made it available to anyone with a connection – and then allowed that person to collate their own information – bringing far greater value to each member of the ecosystem.

Think about it in terms of old media. Before the internet (yes there was such a time) – all of your information was gathered and collated by “professionals” who fed it to you where they decided and when they decided. Newspapers, television , magazines, radio, etc… all depended heavily on someones editorial judgment as to what I might like or be interested in – and to make it all the more clear – since all of these companies were (and still are) for profit entities – the editorial decisions were (and still are) made based on aggregating the largest audience for the information provided.

Fast forward to today and I am my own editor.

On Pandora – I decide what I want to listen to – not some program director looking at the middle of an 18-34 year old bell curve.

With blogs and news aggregators, I am my own Ben Bradlee.

With Hulu and YouTube, I am my own Brandon Tartikoff.

And the great thing is – the more I want to put into my editorial job – the more I am going to get out – almost guaranteed.

Sure there are nights when I want to kick back and watch Lost or 24 (neither of them around anymore alas) – but more and more I spend my time with my own curated information.

Whether I own this information or not is irrelevant to me. I move freely between the differing governments – Facebook, Google, Apple, etc… using each for what I believe is its most relevant facet for myself – and pay my taxes by contributing to each ecosystem. If someone finds my contributions worthwhile – all the better.

And if enough people people find enough other peoples informational contributions worthwhile – well then the value of all the collective contributions has increased dramatically.

New media gets this. Google was built on it. Facebook is a product of it. Apple provides the digital picks and shovels to create and access it. And so on.

If the old media guys are to have any sort of future – and regain any semblance of real growth – then they are going to have to realize that their information –  whether it be in the form of a tv show, a newspaper article, a new song, a movie, whatever – needs to be produced so that people can not only consume it in the traditional manner – but also curate it, embed it, check in with it, scrobble it, clip it – and ultimately make it part of their own creations. It’s only then that they really will be able to move past the traditional – and into the new.

Information is valuable – but in order to really understand its value – you need to understand the ecosystem in which the information lives – or can be used.  The best information can be tailored to all different ecosystems – and ultimately monetized across the lot. There’s not much of that going on – but as I am my own editor – there will be.

Posted by: hdemott | June 9, 2010

The Carried Interest Tax Debate – My Own Take

The last week or so has brought a ton of posts and commentary regarding the issue of taxing the carried interest that VC’s generate from successful investments.

Of late the topic has gotten heated – and the remarks have gone from the benign to the belligerent.

My own take on the matter is that people are confusing several interlocking issues – and getting all heated up about it without really understanding or thinking through the facts and the implications of any changes.

Fred Wilson started the ball rolling at AVC with his post on the subject over Memorial Day weekend  – here. His basic premise is that the carried interest is a fee and thus should be taxed at ordinary income levels – as that is a fair way of looking at the tax.  Others have weighed in in favor of the increased tax – most prominently Chris Dixon here. The naysayers on the tax have come from all angles, but prominently Jim Robinson of RRE here, Jeff Busgang here and BillBurnham here.

All of these posts – whether for or against the higher tax rates for carried interests are well written cogent arguments. What is really impressive however, is the comment threads on these posts which run to hundreds of comments – and are heated to say the least (and thus very well worth the time to read them all). So much so that Roger Ehrenberg today penned a piece talking almost solely about civility on comment threads – using this debate as an example.

Before getting out the scalpel and dissecting all the issues – let me state upfront that it is only because the US has such a great entrepreneurial spirit and culture that we can even have this debate. There’s a reason “Silicon Valley” and the VC system exist in the US like nowhere else – and there is a reason why we an have debates on start-up visas etc… There’s no doubt that we have to pay for the privilidge of living in such an opportunisitic society – but how we pay – and how much is the question that is really open to debate.

So to it:

The carried interest is a fee. No mistake about it. Unlike a management fee (now typically 2% in VC, hedge funds and private equity shops) it is different in that it is a fee paid solely upon the successful sale of an asset after a period of investment. It is thus and artificial construct of the original partnership accounting rules under which almost all private investment partnerships are governed. Invest in an asset and hold it for a certain length of time (1 year for a company – 5 years for a home – assuming you have lived in it) and you qualify for a lower tax rate. As Fred Wilson replied to a comment on Chris Dixon’s blog, “you play the game by the rules that are in place. if you don’t like them, you try to change them” Fair enough. For years the rules have been pretty clear – hold an asset in a partnership for a certain amount of time – and if there is a gain, then someone with a carried interest in the partnership gets paid their fee as a slice of the partnership – retaining all of the tax characteristics of that partnership.

So here we are now intensely debating whether it is fair to change the rules – and in essence  – double the tax on the carried interest from 20% (assuming the Bush tax cuts are allowed to lapse) to roughly 40%.

I’ll skip the details for now – but my view on this concept is that if the government sees fit to tax VC’s, hedge funds, and PE firms at the higher rate – then everyone should be taxed at the higher rate on capital gains. When you start breaking down taxes based on the perceived success of a class of business – you are starting to set dangerous precedents – and really starting to eat into the framework that makes the US such a great place for investing.

As Fred puts it, it is a matter of fairness. I always thought fairness meant that everyone got treated equally. To me that is fair. As your kids what is fair. If you have 2 kids and two ice cream cones – they’ll tell you that it is fair that they each get one. If there are 4 dishes on the table and they are going to clean the table – fair means that each one is clearing two plates. You never hear them claim that one is bigger than the other and therefore should carry 3 plates because capacity is the issue.

Fair is equal.

The media has gotten away from that in talking taxes. In the mainstream media – fair means paying what you can afford – and what you can afford is generally determined by someone who is being subsidized by someone else. When the head tax writer of the House (Charlie Rangel) can’t pay his taxes like everyone else – and the Secretary of the Treasury (Tim Geithner) can’t pay his taxes fairly – is there any wonder why this debate has gotten so vitriolic. Everyone loves the American way – and everyone understands that there is a bill to be paid – so how do we fairly split the check?

This populist sentiment has extended into the capital gains treatment for the sale of stakes in VC shops along with hedge funds and PE firms – and this is clearly wrong in my opinion. Why are these entrepreneurs any different from anyone else? They founded a business, they took risk, they paid taxes at the prevailing rates – and if they should decide to sell, why is that any different than when a start up sells to Google? Why should it be treated any differently? Of course it shouldn’t.

Strangely, you haven’t heard much about this part of the debate – largely because VC firms just don’t sell. They are a collection of individuals with little ongoing equity value in the firm without the founders. While there have been some hedge funds and PE firms that have either sold stakes or gone public – they are the exception – and anyone big enough to really enter into one of these transactions has likely accumulated enough wealth that in this environment it has just become unseemly to complain in public. Am I worth $300M or $400M is not a question that is going to get a sympathetic hearing.

You do, however, hear about whether angels should be taxed differently. The argument goes that angels are smaller – make no money on their management fees and thus have to rely on carried interest – so don’t tax them as much. Of course, this is a facetious argument. No one demanded that they become angels and keep their business small – and no one told them they could not scale it to become bigger and institutional. If you are good enough to be a successful angel – chances are you are good enough to join or grow a much bigger entity – but chances are that you like working with smaller companies at the formative stages – and you don’t want to be beholden to institutional investors – and deal with a mess of partners all competing for capital – and for this reason you remain small. It is a business choice with a real trade off – you have to be right more often.

So what’s really going on here?

We’re not really debating as to whether or not the carried interest is a fee or not. And we’re not debating whether it is right or wrong to raise the tax on it.

What we are really debating is tax fairness – or more properly put – the level of transfer payments from those who have the most to those who have the least.

And why are we having this debate?

I would argue that we are having it because we have a spending problem – not a revenue problem – and the political cost of fixing the spending problem is too high for politicians to tackle – and thus we resort to populist measures like raising the level of “fairness” in the system. When entitlement spending  – be it social Security – Medicare – Obamacare – Public Pensions – are out of hand, and cutting them is political death – you can be guaranteed that the politicians will “kick the can down the road” and tax whoever they can to live to fight another day. If they can do it in populist way “don’t tax me – tax that banker behind the tree” – all the better.

We would all be better off if we just tacked the problem once and for all – and fix the issue.

Since we are not going to do that, by all means raise the carried interest tax – but do it fairly – by raising it for everyone across the board – or by changing the partnership accounting rules – and by no means tax the capital value of fund managers who built up their companies.

Let’s not disincent success – or at least if we are going to tax success to pay for an untenable future – let’s do it evenhandedly.

Posted by: hdemott | May 23, 2010

Notes From the Lazy Boy

I’ve spent almost 5 days in my green Lazy Boy chair here at the command center (okay it’s my sitting room – but I’ve stocked it with 2 computers – 1 60 inch plasma screen with DIRECTV and Apple TV – a land-line (yes they still exist) a cell phone – and a stack of reading materials). Why you might ask?

Knee surgery. Partial meniscectomy to be more precise – athroscopic partial medial meniscectomy of the right knee to be even more clear.

Or you can just watch it on youtube here. Not my knee but you get the picture.

Too old, to heavy, and dreams of becoming a professional paddle tennis player all contributed to the tear. (the 9 sets the day I hurt it probably didn’t help) The body is 43 – the brain is still 13 when I step onto a tennis or paddle court. Tough turning off the competitive gene.

What amazes me – post surgery – is just how weak your knee and leg can get from some trauma to it. This is a minor procedure – yet I need to build everything back up while getting the swelling down. Crutches to start – now walking with a limp – and spending a lot of time with my leg elevated and an ice pack on it. So far so good – but the surgeon will let me know tomorrow how I am progressing.

So with a lot of time to kill and no place but my chair to do it – I’ve worked hard at the day job – but also have seen more television and read more books than usual.

On the TV front – almost everybody should be forced to watch the film Rudy. Yes it is corny – and by now you all know how it turns out. But the message that if you are 100% committed and 100% focused on your goal – and you never lose sight of it – but keep driving toward it – is a powerful message, and one I believe people forget and give up on. The most successful people I know – financially or otherwise – are like this, extremely focused and undeterred.

I’m currently reading Jeff Bussgang’s book – Mastering the VC Game – which is a very interesting read. Having done a deal with his firm, Flybridge Capital Partners (we both invested in a company called Zing which was ultimately sold to Dell. I worked on this with his partner Jon Karlen) I am of course somewhat personally invested in the book.

I am always amazed how the VC world is really run out of 3 places (Silicon Valley, Boston and NYC) and how most VC’s tend to invest only in their geographic area – largely because they are busy and want to be close to their investments so they can monitor them with a minimum of fuss. What is so amazing to me about this is that simultaneously, they are dumping millions into companies to allow us to better communicate, to better share data, to better stay on top of things – but at the end of the day – they still value face to face interaction above all else – and don’t want to waste time getting on a plane to achieve it. Between advanced video conferencing, multiple cell phones, twitter, blogs, e-mail, instant messaging, SMS, shared powerpoints, etc… we should be able to have all the communication we want – but the board meeting is a time honored tradition that companies do not want to mess with.

Go figure.

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