Sunday, March 23, 2014

Patrimonial Capitalism

This notion has been stewing in me for quite a while, and yesterday Paul Krugman wrote an article about this topic of Patrimonial Capitalism.

"...the political spectrum now instinctively accords much more respect to capital than to labor, at a time when capital income is growing ever more concentrated in a few hands — and is surely on its way to being concentrated largely in the hands of people who inherited their wealth."

This is somewhat related to my earlier post of how I wish things were - with a balance between owners, employees and customers - called Capitalism and the Three Legged Stool.

In Krugman's article, the basic premise is that since wealth and income are concentrated increasingly in fewer people's hands, the society at large is dependent on the patrimony, or direction, of the 1% (or maybe the .1%).  Decisions like Citizens United help to reconfirm this, as those with large wealth can now invest to shape the government.

These topics have been beaten to death, but I wanted to expand on my own experience of how this plays out in helping to determine the probability of financial success.  I want to point out two examples of how the tax system is set up in a way to help people with wealth.

Capital Gains as a Tax Break for the Wealthy.
This is the primary issue that Warren Buffet is referring to when he talks about income inequality.

I am lucky to have been a small part of several companies that either went public or were sold. The primary way I have made money over the past 15 years is via capital gains, which were taxed at either 20 or 15% rather than the marginal tax rate of 35-39%.

In two ways, that seems fair. I chose to be paid in stock rather than income, therefore taking the risk these companies would not become valuable.  Second, I was part of teams that created something out of nothing and created jobs, which is what the American Dream is all about.

However, it bothers me that people that chose to work at these companies did not have a similar choice.  First, because only the top people are offered this type of incentive. But also because they did not have enough money to forgo a salary.

Also, most of the venture money came from either wealthy individuals or from non-profit funds like private and public pension plans and University endowments.  Obviously the non-profits would have invested no matter the tax rate. And the wealthy individuals were looking for those big 10X returns as the reason they funded these companies, so tax rate was a relatively minor part of their investment thesis.

My point is that this capital would have been available to fund these companies even with a higher or non-existent capital gains rate.

Capital Gains Treatment Does Not Encourage Building Businesses for the Long Term
Although the Capital Gains tax is designed to encourage long term investing, there are a number of ways it does not.  This is seen today in venture capital backed companies.  The VC backed companies are mostly designed to grow fast and be attractive to a buyer so that the principles can cash out with low tax rates.

Let's take it from my view as the founder of RunSignUp.  Unlike my other companies, this one is not venture backed, and was funded solely by me (another advantage of having money).  We have grown fast and are now a profitable company.  Since I own it, that profit is now taxed at the marginal tax rate of 39.6%.  For me, that is fine and I am happy to pay that given the fact that the company would not exist without the wonderful infrastructure, people and wealth of our amazing nation.  I also happen to really enjoy the work we are doing and want to continue for hopefully a couple of decades.

But we have already been approached about being acquired.  Think about the advantage of the 20% Capital Gain rate.  Greatly simplified, it would allow me to keep an extra $20 out of every $100 of value of the company to sell it.  And if I were the type of person to maximize my profit, I would try to grow the business unnaturally for today and leave future investments until someone else had to worry about it to maximize the sale price.

That does not sound like the basic idea of building long term businesses via a capitalistic system to me.  It sounds like a system that maximizes the wealth of the wealthy.

To bring this back to the topic of Patrimonial Capitalism, the wealthy who are looking after the interests of the country have seriously stacked the deck in their own favor.  I see this personally, and like Warren Buffet, it bothers me.  And I just wanted to get that out of my system...

Sunday, February 23, 2014

WhatsApp Valuation Model

I finally had a moment to figure out the Whatsapp business model. First year is free and then $0.99 per year thereafter. With 400 Million users, that is about $400M in revenue per year (or per next year). 

They do 18 Billion messages per day. Using Amazon AWS SQS or SNS pricing of $0.50 per Million, that is $9,000 per day of approximate cost, or about $4M of costs per year. I know that is probably a bit light because I am not including data transfer costs of about a Nickel/GB. 

For employee costs, they had about 60 people at an average fully burdened load of $200K is about $11M.

The big cost for WhatsApp are the Apple and Android Store transaction fees of 30% - about $120M.

So, a net income (next) year of ~$260M. 

Put that net at a 73X P/E ratio and it gets you to the $19B valuation.  Comparatively:

  • IBM has a PE of 12
  • Red Hat has a PE of 64
  • Facebook has a PE of 112
  • Amazon has a PE of 580.

Of course it positions Facebook well to address some challenges it has.  The two big ones that come to mind is that the Facebook app is too big now and therefore they need some other brands and apps to get to market if they want to continue to grow.  The second one is that they have set Facebook up to be an advertising driven model (although there are some huge opportunities still to do things like payments and identification). The WhatsApp subscription pricing gives them some diversity in their revenue model moving forward.

Anyway, I'm pretty sure Zuckerberg did not make a huge mistake here.  And I think Facebook will continue to bring new brands to market thru development or acquisition just as Google has.

Thursday, February 13, 2014

Capitalism vs. the Three Legged Stool

Wikipedia defines: "Capitalism is an economic system in which trade, industry and the means of production are controlled by private owners with the goal of making profits in a market economy."

This definition has always bothered me. I prefer a different model where there is equal recognition of the three primary drivers behind the success of a company:

  • Owners
  • Employees
  • Customers
I like to think of it as a three legged stool, where each leg is as important as the other.  One gets too large or small and the stool tips over.

The free market is supposed to take care of Employees and Customers.  Employees because the Owners will create so many jobs that due to supply and demand, employees will receive competitive pay.  Customers because if the owners are not building the right thing, then they can go elsewhere.

As someone who has helped to build about 10 startup companies now, I have seen the power in making these three stakeholders equal partners. 

Employees who are true stakeholders - both financially and in shaping the company - are much more valuable to the other two stakeholders since they have high motivation. In addition, employees who take true responsibility make better decisions and work harder.

Making customers true stakeholders is similarly productive. I have seen Customer Advisory Boards have real and meaningful impact on companies. Customers know their needs the best - employees still have to listen and interpret and make bets on where the customer will be in the future. Being able to have honest dialogs is important, because new ideas stem from these interactions when there is true collaboration. Companies need to charge a fair price to their customers and deliver true value for that price.

There is a requirement from all parties to share the power and have empathy for each other.  That means customers must understand an employee's need to earn a good living, and an owner's need to get a return on invested capital (and time).

As owners, employees and customers, we all share the individual responsibility to make the organizations more equal across these stakeholders. I like the recent commercial on TV about the employer who gives 20-30% of profits to employees

We work hard at RunSignUp to make this true, and it is certainly a competitive weapon that helps elevate our business above the typical pure capitalistic companies in our little market. Hopefully it is an approach more and more businesses take to heart.

Wednesday, December 18, 2013


Alex McCaw wrote an excellent blog explaining stock options -  Everyone getting options (an engineer or not) should read this - especially the tax implications of converting your options.

I thought there were several common issues that could use some further explanation using an example.

For our example, lets say a VC investment made of $10 M at a valuation of $50M.

Pre Money and Post Money Valuation.  Since people like big numbers, so this is usually expressed as post-money. So the company was valued at $40M before the investment, but now that they have another $10M in the bank, they are now worth $50M.

Dilution.  Before the investment there were 4,000 shares/options, each worth $10, and each representing 1/4,000th of the company.  For the investment another 1,000 shares were created and sold to the investors at $10 each.  Each share/option each employee had was worth $10 before and $10 after - so there was no economic dilution.  Each share/option is no representing 1/5,000th of the company - so there is a % ownership dilution.

Dilution can be an emotional topic.  For founders as they go thru rounds they drop from 60% ownership to 30% to 15% and feel a loss of control of the company. But this is the deal for getting those financial resources into the company. Dilution for most employees does not impact "control", but a feeling of "worth".  They may start with 1% but at the end be at .2%. The fact that each round was needed and valued "fairly" means it was just part of growing the company. Just like adding another superstar developer or VP of Sales. 

The point I would like to make is that company leadership should explain this during the growth stages and when new investment comes in.  It is a simple fact and should be treated as such. Don't wait to sell the company and people think they have 1% and they actually have .2% - too much heartache when there should be celebrations.

Option Valuation. In our example the valuation is $50M, but that valuation is for Preferred Shares. The reality is that Common shares (which options are tied to) are NOT worth that much. The reason is covered in Alex' blog. Boards will try to get a valuation done for the company at the lowest possible price.  These days that is about 20% (and it seems to have gone up over the past 10 years and continuing to head upward). Boards have a reason to try to get the minimum valuation because it is an incentive to hiring people, so in this case boards are definitely on the side of the employees!

So that means if you are issued options around the time of this funding, your options will be priced at $10 * .2 = $2. So, if the next week the company is sold at $50M, you are in luck because your options will be worth almost $10 a piece! (it is "almost" because some preferences may wind up giving some of that first $50M to the preferred shareholders).  Of course if the company sells for $10M in a year, then the preferred shareholders get all $10M and you get nothing - hence the reason for the decreased value of your options.

Who Deserves How Much? This is one thing I have learned - no one gets what they feel they deserve. At some very successful IPO's and Exits I have been a part of I have seen unhappy people from the founder to the CEO to the Exec team to developers to sales people - well, everyone. It seems some people always have a high opinion of themselves! 

The fact is that there are four key things that determine how much you get:
  • When you join. The earlier the better.
  • How much appreciation to the value of the company happens after you join.
  • Accepted Market Practices. All the VC's will have a chart for what % each type of job function gets they will share with their CEO's. That provides ranges, like .7-1.5% for a VP Marketing. The interesting thing about most that I have seen really focus on the people that report to the CEO, so the typical % going to a developer will be much below 0.1%.
  • How critical the open spot is and how good you are. 
So negotiate the best you can, but the big wins come from being part of a company that grows really fast and increases their valuation 10X while you are part of the team. Good luck on finding that opportunity. 

In the mean time, enjoy your job and live within your existing compensation!

Monday, November 18, 2013

JBoss Recollections - Part 5 - The Business Team

My daughters, Mollie and Allison, in
Neuchatel, Switzerland waving the JBoss flag
I have covered other JBoss Recollections previously: 1. Early Years, 2. Forming the Strategy, 3. Tech Team, and 4. VC Funding.

Of course any real business needs business people to drive success and growth. Here were the key hires by date and some stories behind each. Looking back, I still think we made the right decisions on each of these great people as well as the timing and order of their hiring. That was one of the many lucky things that happened to make JBoss successful.

Marc and Ben
Ben Sabrin - 2001 - Ben was at JBoss before I got there. I've talked about Ben in the earlier recollections, but I would be remiss to not mention his significant contributions to JBoss. He figured out that customers wanted to buy from JBoss before almost anyone.

Tom Leonard - 12/03 - I knew that the key thing about making JBoss successful as a business was credibility. And there were two major ways to earn that credibility from a business perspective - Significant Partnerships and Significant Deals. And I happened to know the one person in the world who could help us the most - Tom Leonard.  Tom and I had worked together at Bluestone where he had almost single handedly
brought in most of the Partner business. He also had the ability to close large deals. And best of all, customers loved him. He closed Unisys, HP, Novell, Iona, McKesson and many others. Tom and I were also the ones to establish the relationships with Red Hat and Oracle that led to the eventual acquisition. I went with him on many of those meetings and never paid for a meal ;-)

Cary Smith, CFO - 1/04 - So we had a bunch of money from VC's, and we needed someone to start having some ownership of that as well as the budgeting process. Cary came from Earthlink and brought the discipline and experience needed to plan and run our operation. This was critical because we tried to operate the business on a relative cash flow break even basis, and knowing where we really stood on cash, collections, planned expansion when growing from 6 to 200 in less than 3 years is tough.

Joe McGonnell, Marketing - 2/04 - David Skok, our lead VC, had helped develop the strategy of a marketing driven funnel. I had worked with Joe at Bluestone as well. He not only knew the middleware market, but he was a pragmatic marketer that who was responsible for putting together the people, systems, and processes of a market driven funnel approach. Joe made a major career bet on this company at a very early stage and moved from New Jersey to Atlanta to be one the keys to our success. He somehow implemented David Skok's scratchings below:

Rob Bearden, Sales & Marketing to COO - 4/04 - It was clear that JBoss was growing fast and significant companies wanted to do business with us. We needed to put in place a way to keep up with the demand and take advantage of the opportunity in front of us. I still remember meeting Rob in the Atlanta airport the first time. I instantly fell in love with him. I felt he was so right for the job of getting us organized, disciplined and aggressive in going after the market. He would bring the right amount of professionalism to our organization and make us credible. He did many smart things in his early days like leverage existing talents like Ben and Tom. He also asked Matt Quinlan to put together training for sales and SE's so we could scale the organization. As the company grew he became the COO, which was exactly the plan that Marc had laid out when he was hired. I remember lots of stories about Rob. Between taking a vow of no meat or alcohol during Lent, to his farm truck he drove to work with 4 tires in the back, to his Monday morning sales team calls he was a colorful driver of the JBoss business culture.

Brad Murdoch - 7/04 - We were growing so fast, we needed help in organizing the operations of the company - especially our delivery of training and support. I still remember my first interview on the phone with Brad - the energetic Scotsman practically leapt over the phone from San Diego with his enthusiasm and drive. He was a key person in creating the type of credibility with customers to earn major contracts for our young company. For example, he was critical to gaining what was the largest deal of the company from Nokia by committing his personal support and giving their executives his personal cell phone number.

Shaun, I think...
Shaun Connolly - 10/04 - I had tried to convince Marc of the need for Product Management for quite a while, and I finally wore him down by introducing him to Shaun (another former Bluestone guy). Shaun learned the open source game at JBoss, and how to work with open source developers who were very head strong and geographically dispersed. He later helped Spring in their very similar growth efforts, and is currently at Hortonworks. There are two great things about Shaun. His humble nature, and his son. Billy has built two apps now for RunSignUp while in high school. He is far, far brighter than his father. Shaun and I are a lot alike in that we have both gotten to the point where neither of actually do anything.

Rich Friedman - 12/04 - Rich is the guy that made JBoss scalable as a business. He created the JBoss Operations
Rich's baby...
Network, which was the key value-add that made JBoss acceptable and enticing to the Operations departments in many organizations. It allowed the sales team to justify the value-add of our Subscription Services. I still remember meeting Rich when he was interviewing at Bluestone and him opening the trunk of his car and getting out a book - there must have been a dozen programming books in his car. I am lucky to still call Rich a friend and actually collaborate with him still on RedLine13 as a side endeavor that we use as an excuse to get together still.

There were many more that I was fortunate to work with. I guess my point to this series of recollections is that there is not one single point in time, no single decision, no single person that makes a company truly successful.  It is the accumulation of a lot of hard work, a lot of learning and adapting, a real sense of a team, and of course having fun along the way.

Thursday, October 24, 2013

KK, Jenkins and the Triumph of Technology

Kohsuke Kawaguchi is the most brilliant developer and creator I have gotten the chance to work with (we work together at CloudBees). I just got back from the Jenkins Users Conference, where 450 people from around the world (literally) attended and another 500+ watched via live video stream.

In his keynote, KK reviewed his concerns with having created Jenkins.  (It is the defacto "Continuous Integration Server".  Many, many companies use it to "build, test and deploy" their software - meaning it winds up being the glue that glues the pieces together of many of the applications people use today like Yahoo, Netflix, EBay, Amazon Kindle, cell phones, etc. Not to mention big companies like Cisco, AMEX, Macy's, Nordstrom and literally tens of thousands of others.)

To "build, test and deploy" all of these applications, he estimates it takes 3 Facebook sized data centers running pretty much full time 24 hours a day, 7 days a week, 365 days a year. He was concerned about contributing to global warming. He rationalized it when he found a very large wind farm that produces enough energy to run these three Facebook-sized data centers, and has promised to continue to work on this great project.

KK created Jenkins when he worked at Sun under it's original name of Hudson.  There he incubated it and started an open source community.  I've always liked open source and had tremendous respect for those developers who created successful projects. Open source is like showing everyone in the world exactly everything that you have done (how many people are willing to show all of their work in public?).  It takes a lot of courage to do that, and if you are able to create a project that people use enough to fill up 3 FB data centers then you have really done something.

I respect KK more because of how he saved the project from Oracle back in 2010. Oracle had purchased Sun and there was a mindless manager who tried to corrupt the project.  KK stood his ground when Oracle started doing really stupid things, and "forked" the project.  This was a huge decision on his part since Hudson was his baby, and he would have to restart many things (thank goodness for open source and he did not have to re-write the code).

Jenkins was born in late 2010. Oracle fought this hard. By February it appeared that Jenkins was going to be the winner. This was a very, very trying time for KK.  

With the success of Jenkins that was aptly demonstrated today, KK made the right decision.  

There are two key reasons for the success of Jenkins.  First is KK's brilliance in seeing a problem and creating great code that solved the problem. The second is the community that has built up around Jenkins. There are two aspects to this community. One is the fact KK architected Jenkins to make it easy for others to "plug into".  This has led to hundreds and hundreds of plug ins that provide a solution far broader than any single company could offer. The second aspect of the community is people's willingness to help. Whether it was Tyler Croy's support and help or Andrew Bayer's calm guidance and graphic capability to create the new Jenkins logo.

And this is where KK separates himself from the amazingly few other brilliant developers. His ability to build that community. The picture at the top of this blog shows KK kneeling down to sign autographs today on a butler bobblehead (he signed these for over an hour today). His humble bearing - kneeling at the feet of others, selecting the butler icons for his project to demonstrate the fact his software was meant to serve others, or giving the shy, embarrassed smile when he sees the line of autograph seekers getting longer all are the essence of why he is successful.

Thank you, Kohsuke. For giving us the chance to learn from you and sharing your creations in the unselfish way you have.

Thursday, July 25, 2013

Venture Funded vs. "Lifestyle" Startups

I get pinged a couple of times per week by people about starting up a business.  Almost always the question is "How do I get funded". My common answer is take money when you don't need it, because that is the only time when people will want to give it to you. And don't take money when you need it, because people won't want to give it to you then.

Why I was a Fan of VC Funding
Here is an example story. In 1994 Bluestone had created a tool that made it easy to develop applications for the web that were driven from a database.  Today this is how all websites work, but it was the early days.  We were funding the development ourselves out of cash flow, and investors approached us - Bessemer actually gave us a term sheet. The founder declined.  Our competitors (Spider Technology, which became NetDynamics) got funding and we were forced to respond to match their higher levels of spending and go look for venture funds.  Of course when we did, our final term sheet with Patricof and Adams was lower than the original one from Bessemer 18 months before (and we had lost a year and a half of time).

I became a pretty big cheerleader for getting venture capital. In addition to being able to be more aggressive in development, marketing and sales, it also brought a discipline with outside board members that was healthy to challenge and motivate and bring structure to the business.  When I joined JBoss, Marc decided to take venture investment.  It is safe to say that David Skok of Matrix added a lot to the company, in addition to giving us the capital to move forward aggressively in the market.  Similar positive experiences happened at Hyperic and Spring. Currently I work with several companies including CloudBees and eXo who are venture funded (appropriately because they are going after big problems in big markets). And from a personal basis, I have enjoyed making most of my money from capital gains of appreciated stock.

Why I now like "Lifestyle" Businesses
When talking with VC's, they will kind of look down their noses and ask founders if they are interested in a "lifestyle" business.  It is almost presented as a choice between being lazy or taking funding.

I think the world has changed quite a bit, though. The cost of creating a product and bringing it to market are drastically lower in the technology space. The Cloud allows people to develop a service that can be used by Billions of people instantly.  If it does not catch on the cost is minimal, if it does catch on it is very low cost to expand.  The cost of marketing and sales has also dropped tremendously - there are fewer and fewer "enterprise sales reps", and the best marketing is viral and true word of mouth.

In essence, it is cheap to start web based businesses today. And funding will not improve the chances of your idea being good or not.

I am going the "lifestyle" way on my two latest startups - RunSignUp and RedLine13. The first started in 2010 and we have grown on a grass roots basis.  We develop features in an incremental fashion. As we add features and capabilities, we are able to address more and larger races needs. It is a self-fulfilling realization of success. Our desire is to create a great service for our running community and build a solid, profitable business. This is not saying that Eventbrite is bad for taking $140M of capital and building a very large business - just that this alternative is a very good one for a lot of entrepreneurs.

In the case of RedLine, we just launched this service as a part time effort.  It costs us about $3,000 per year to operate it as a free service.  We are seeing encouraging signs of early adopters coming to us.  Perhaps we could go get venture funding for it, but then we would be like all the big competitors and wind up with similar pricing. If we stay small, then we can have a nice little profitable business that helps customers.

With both of these companies, I get that dismissive, "oh, a lifestyle company, isn't that cute" kind of feeling when talking about them with my friends in the industry. In reality, I have a lot of fun with both businesses and will make a lot of money with both.

My Recommendation
I was on the phone with an entrepreneur yesterday who was looking for $500K. I told him if he went to professional investors they would basically string him along until he was producing cash, at which time he would not need their money. In his case, he is better off taking his time with development and not hire another developer right now. Build the product his first 3 customers want and then move to the next set of features from the next set of prospects. In a couple of years he would have a profitable business that would either produce a nice flow of income or be very attractive to acquirers. And he would not have wasted 6 months of his time chasing funding rather than figuring out creative ways to build the business.

While it makes a lot of sense for some businesses to seek funding, there are a growing number of opportunities that you can grow with very small capital needs. The goal is building a business, not getting funded. Even if people think it is a lifestyle.