Sometimes Money isn’t Enough

Over the course of the past several months, I keep running into internet companies which are arbitraging what their customers will pay for a constituent to take a given action, and what they need to pay the constituents to take this action (more on that in a second).  I want to dive a bit into what I consider a flawed business model, and how these companies could be improved.

There are a few examples of this type of business.  Wellness companies are paid by self insured employers to promote incentive plans where employees are given reward cards and other token items in exchange for going to the gym, eating better, and generally taking care of their health.  If the employees do this, it cuts down on their overall medical bills, and the days when they are out sick, thus saving the company the cost of paying for care and lost productivity.  The company pays the wellness company which takes a cut and then pays the rest to the employee in the form of gift cards.

Another example are the product check-in companies which essentially pay consumers to interact with brands at a physical store.  A consumer walks into BestBuy, takes a picture of a product with their phone, and then gets a gift card as a reward.  The check-in company would take the $10 they got from BestBuy (their customer), and pass $5 along to the consumer.  The hope was that engagement with the product would result in increased sales.

These strategies are simple enough, and seem to make sense.  Pay someone for doing something you want.  And, pay them less than the value you accrue from their action.  However, I’ve yet to hear of a company strictly sticking to this model which has taken off, and I think it’s because they aren’t changing the actual behavior of a person.  For example, I might walk into BestBuy and snap a photo of the latest RIM phone if I can get a $5 gift card for doing so.  But, I’m not going to do that every day, week, or even every month.  I have better things to do, it’s not all that fun, and $5 is not a compelling reward.  Similarly, I might go to the gym 10 times per month for 2-3 months if it’ll get me reward points which I can turn in and buy real products.  But, I’m eventually going to revert to my old habits once the novelty of the prize wears off.

In order to change behavior, you need to appeal to something more powerful than trinkets, like social pressure.  For example, if there was a chart shared by my friends that showed how often I went to the gym, I’d probably go more often.  I’d show I was taking care of myself, and I’m sure if I slacked off at all they’d let me hear about it.  Layering in positive feedback mechanisms would make this even more powerful.  To me, this is a much more effective model.  And, I’d be curious to hear about any businesses that have used a hybrid rewards/social model, or perhaps a purely social model to great success.  Feel free to drop me a line.

My Pinky, and What’s Wrong With Healthcare

I always find it very interesting to hear the story behind just about anything (a business, organization, town, person).  And, I was lucky enough to know some of the “story” behind what was going on with my pinky last weekend.

During a freak kickball accident last weekend (don’t worry, I got the person out), I ended up dislocating my pinky.  After jamming each of my fingers countless times during my wrestling days, it finally took a sunday kickball game in the LES to cause any sort of damage that warranted a trip to the emergency room.

Mistake one was going to the emergency room.  I am well aware of, and actually sought out, urgent care centers in Manhattan.  Unfortunately, none were open on this fateful day.  The sight of my pinky completely mangled urged me to try my luck at the NYU hospital and give up the search for a potentially better alternative.  For the undeducated, urgent care centers are like mini emergency rooms, they are specialized and super efficient so that they get you in and out in an average of 45 mins (ER average is 4 hrs, and 70% of visits can be handled by urgent care, which is also cheaper).  Apparently these business haven’t fully penetrated NYC yet, maybe real estate is a bit too expensive.

So, I spent 5 hours in the ER.  After 2 x-rays, some novocaine, a splint, a lot of time waiting around, I was finally on my way out.  I consumed a lot of resources, and unnecessarily, at that hospital.  But, there was still more to come.

For my little dislocated pinky, that took 45 seconds to relocate after being properly “diagnosed”, I also had to see a hand specialist.  In the days of malpractice paranoia, every precaution is taken, even if it means spending lots and lots of money on people’s pinkies!  The hand specialist of course wanted to do another x-ray.  Did you know medical images are actually transmitted through CD most often?  So, of course, the ER couldn’t send either of my two previous x-rays to the doctor in time for my visit.  Companies like Life Image are trying to solve this by setting up networks through which medical images can be transmitted digitally, but it takes time to fix a broken system.

And, of course, my new doctor owns his x-ray machine, and doctors who own their machines take 5x more x-rays than those who don’t own them.  This is how they make the big bucks.  In fact, an entire industry has popped up with companies like American Imaging Management providing radiology benefit management services.  I got a call from these fine people asking me what the heck was going on with my finger.

But wait, that’s not all.  My new doctor also found some sort of gray mass on the x-ray he didn’t understand and so thinks it’s appropriate to get a CT scan.  This probably brings the total spend on my finger to well over $1,000.  All this for my little pinky that would have been popped back in by a trainer in any sort of scholastic sporting event.  And that is what’s wrong with healthcare!

The only remotely interesting part of the ordeal was seeing several of the emerging companies I’ve run into at Bessemer, or at least the problems they are trying to solve.  At the very least, going to the hospital is a great way to find new investment roadmaps!

Beating “Efficient Markets”

I touched upon my dislike for the Efficient Market Hypothesis (EMH) in an earlier post, but thought I’d bring it up in a little more depth here.

The EMH is a framework for thinking about the stock market that is taught in many undergraduate and MBA programs.  Basically, the theory states that all information that is publicly available is reflected in a stock’s price.  So, when a company announces a new partnership, the stock pops at that moment and perfectly reflects the expected value of this new partnership.  The information made available to the public is now supposedly reflected in the price.

But, the reality is that not all information is readily available (even if it is public).  And, many times you have to dig.  That may mean calling on people in your network who have specific knowledge you’re after, reading obscure blogs, or reaching out to someone who is in the know.  We do this a lot at Bessemer to try to better understand industries and companies we are interested in.

I’m bringing this up as a result of my experiences in our ongoing efforts to find a new analyst to start this summer.  We’ve interviewed a lot of candidates, and many of them have made me realize how lucky I was to have gotten this job in the first place (there are a lot of smart people out there!).  But, the few that that have stuck out obviously did their homework to understand the job, the recruiting process, and woven these knowledge points into their interviews.  They’ve read a few blogs written by our professionals (especially the posts about the analyst recruiting process, which exist), researched our portfolio, and have asked friends in VC what it’s like.

The 5% of candidates who have done this work have stood out – and in my mind they have gone beyond what is public knowledge of our firm and what we do, in order to give them an edge.

More generally, this type of digging seems to be what separates people who are pretty good at something from the people who are the best.  When I talk to friends working at some of the most successful hedge funds, I ask how they can make money on a consistent basis when so many people fail.  The answer is almost always that they spend extra time figuring out what exactly is going on in a market, and going off the beaten path to solidify their investment thesis.  They are rewarded quite quickly through higher returns and a bigger pay check.

But, I think this sort of methodology applies to many facets of life beyond investing: everything from sports to building a business (MyCityWay for example is a company that is leveraging publicly available info to build a cool mobile app – apparently few others building this type of app had came across these data sets).  And, I can remember back in my wrestling days breaking down tapes of Russian wrestlers to try to learn techniques that my opponents hadn’t seen before and wouldn’t know how to defend.

These sorts of data are quite valuable, but even more so is the mentality of digging in order to get an edge.  I just hope I can keep that mindset and try to find new ways of getting those advantages as life goes on because I truly feel those small advantages add up in a big way over time…

Disrupting The Dating Scene

Well – no, I’m not talking about running shirtless through a speed dating session or getting into fights over members of the opposite sex at bars (all of which I would call “disruptive”).  Although, that would be a really fun post.

The Spark

A friend of mine met his girlfriend through  And, ironically, she was only a second degree of separation away – meaning that one of his friends actually knew this girl.  If this common connection knew both of these love birds, why did he not connect them in the first place (instead of making them resort to online dating)?  More importantly, how powerful is our second degree network?  I’m sure that this force has been harnessed by all of us at one time or another to get a job, or borrow a car for the weekend.  And, hopefully there will be easier ways of utilizing this resource through the evolution of social applications (LinkedIn comes to mind).

So, we’ve identified an opportunity.  Instead of meeting your future consorts through an algorithm (, or out at a bar (life), why not leverage the power of the people that know you best to find suitable potential mates?  How do we do this?

The Idea

My first reaction is to build an application on a social network (probably facebook) that allows a common connection to “match” people.  Basically, if I know my friend Cindy and my other friend John who are in mutually exclusive social circles are both single and I think they’d get along, then I put them in contact together.  Maybe if they email each other I get points, and if they actually end up dating I “level up” to a “matchmaker.”  Game mechanics would basically drive people’s incentives to match up their friends.

Also of interest, I’ve found that several people simply go through a friend’s facebook pictures in hopes of finding Mr/Ms Right posing for a candid (as strange as that sounds to actually write down).  What if, after not so creepily perusing friends’ facebook pics in hopes of finding mr/mrs right, we could tell our mutual friend in common that we were interested in being set up.  The key is to indicate that you want to be connected, and then have your friend actually put you together.

Here’s another example of one’s second degree helping out:  Say you want a job in advertising in New York.  If you have 30 friends that live in the city, then you’re probably going to have a few 2nd degree connections to advertising execs.  What if there was a way to let your network know what you’re looking for, and actually stay top of mind?  Would people be willing to pay to be on someone’s dashboard (where a dashboard is a listing of people you know who want a job/date/apartment/etc)?  And, why are people checking their dashboard in the first place?  Maybe they are seeing if any of their requests are fulfilled.

Maybe some people have to pay to be on someone’s dashboard, and others come up to the top because they’ve done that person a favor before, or are a highly valued contact (do your boss a favor and maybe she’ll return it later).  Food for thought.

China Vs. The US, which would you buy?

Recently I ran into a company which was contemplating buying one of their competitors – not an uncommon conversation as Bessemer sometimes finances these types of transactions.

The company I was talking to is on a tear, growing at 150% annually, flirting with profitability, and has a best in class technology.  For reference, let’s say the acquiror is around $7 million in revenues.  To complete the picture, the business they’d like to buy is a stodgier business, has been around for the last decade or so, and has some decent customers, but the product isn’t that great and they are going to get beat by their competitor in the future unless something changes.  The target is around $21 million in revenues, with $5 million in profits, and 5% growth.

So, which would you rather own: a company 1/3 the size, with no profits, but strong growth and what appears to be a much better product?  Or, a solidly profitable company (which you could put debt on), which has been around the block and is 3x the size?  Which is worth more?

The answer is that if the company growing at 150%/year is growing for the right reasons (a truly better product, better customer acquisition strategy), and those reasons also point to it being the better long term bet, then it’s very feasible the fast growth will continue and quickly make it a larger company, and thus worth more today.  And so, the smaller company buying the “larger” one makes sense.

This somewhat analogous situation sparked an interesting conversation with one of my colleagues over the value of the US relative to China (if you were to think of them as two different companies – although I’m not sure either will be buying each other out anytime soon).

For those unfamiliar with the numbers, the US has a $14.6 trillion GDP (or $2 trillion in taxes, which is more akin to revenues), 2-3% growth, huge losses each year (trade deficit of $500 billion in 2010 alone), and a horrible balance sheet ($14 trillion in debt, here is a scary site:

China is growing at 10% per year, with $5.7 trillion in GDP ($1 trillion in taxes), a $185 billion trade surplus, and a balance sheet that includes $1+ trillion in US treasuries alone.

Of course, there are a thousand other metrics, both economic (unemployment rate, hourly wages, industries driving growth), and social (education, cultural values), but I think the above gives a decent picture, just as the revenues/profit and growth of the two companies give us a quick picture of what is going on with their relative values.

The US growth may have slowed a bit, but we are still 3x the size of China, have loads of talent and the infrastructure to support growth.  We can essentially borrow at will (cost of US debt is still well below 4%).  And, some none economic factors like a culture more suited for innovation, the world’s best equipped military, and 100 other things make me think the US is still the right bet to make.  It’s interesting to think about nonetheless.  Maybe someone should create an exchange where you can essentially bet on countries (or maybe that’s what a combination of country focused ETFs and the rates market already is).

Quick Thoughts On Travel Zoo (TZOO)

If I’m not mistaken, in a few hours Travel Zoo (TZOO) will announce earnings for Q4.  This stock has been hyped due to it’s expansion into daily deals and has gone up 300% of so since the summer.  And, as the Yipit guys pointed out, the deals segment is now valued at around $400 mm.

As a disclaimer, I own a small amount of Travel Zoo which I bought a few months back.

Quickly, many of these daily deal sites have been valued at around 3x the run rate net revenues (the amount of cash that actually goes to the company in a month – i.e Groupon charges you $50 for a coupon, but only takes 40% of that for themselves with the rest going to the merchant.  That 40% is the net revenue).  You can check out the Spreets/Yahoo acquisition as a comp.  The numbers haven’t all been posted, but you can do some easy calculations to back into a run rate net revenues number and figure that they were bought for around 3x.  By the way, run rate here is simply taking last month’s revenues and multiplying by 12 (annualizing the number).

So, do we think that TZOO is doing 450 mm / 3 = 150 mm in run rate net revenues?  This would imply 150/12/.4 = 31.25 mm in monthly revenues for January.  The math is net revenues/months in a year/the amount of net revenue that TZOO collects as cash to them.  This would seem like a lot, especially considering they just launched 6 months ago.  However, the company also has a 20 mm member email list, access to capital markets (which potentially means they should trade at a premium to 3x gross profit due to better liquidity than a smaller, private company), and a proven management team.

All that aside, I’m more interested in knowing what the market thinks will happen, which will be evident by the change in the stock after the data is actually released.  What if they are doing 10 mm in monthly revenues and that is enough to see the stock rise 15%?  Does that mean people are just being irrational?  Time will tell…

Note: As stated above, I have a small amount of personal money invested in TZOO stock at the time of writing this post.

Some quick thoughts on Facebook’s Valuation

There is a lot of buzz on the Goldman Sachs investment in Facebook.  If you haven’t heard, Goldman is buying $1.5 Billion worth of facebook common stock at a $50 Billion valuation to give to their clients.  The gist is that they’ll be selling this stock to some of their choice clients in anticipation of a Facebook IPO.

I was watching MSNBC, or one of those business news channels (something I never do) on my plane ride down to the Caribbean last week and the talking head mentioned how Goldman is essentially betting that Facebook can charge a subscription fee for their service and generate large revenues that way.  When I heard this statement, I realized how misunderstood tech “startups” truly are when it comes to mainstream investors.

Facebook is a powerful platform that will drive more and more revenues from advertising, virtual goods, eCommerce, and potentially other revenue streams (more niche social applications like dating, more robust gaming capabilities, etc).  But, I don’t think they will ever charge subscriptions – the value is in the information they can glean which comes from large numbers of engaged users which in part comes from the fact that facebook is free.  I don’t even think debunking this theory deserves more thought than that.

So, what about $50 Billion, is that crazy?  Well, there are lots of rumors about what Facebook’s current revenues and cash flows look like.  I’ve heard that a lot of the reported numbers are inaccurate, so I’m going to refrain from looking at a multiple of revenue or cash flow since we don’t really know what the numbers are, and I don’t think that’s the right way to look at things.  Plus, what could possibly be a comp for facebook?! (as an aside, the best comps would probably be “game changing” companies that got to scale – Netscape, eBay, Google, etc).

One way to think about its value is to understand what the future gross profit Facebook can generate from each user is, apply a discount rate, and get to an enterprise value.  Here we are thinking about value in essentially the same way as a discounted cash flow valuation (which I usually think is pretty weak, but works in this case).  Think about it this way – a typical brick and mortar retailer will value a customer’s email address at $8-$13 (let’s say $10).  That’s because they think they can sell you enough goods where they will get that money back in gross profit over your lifetime as a customer.  So Borders spends $$ to get your email by incentivizing sales people to get you to sign up for loyalty programs, or offering you discounts, so that they can get your info and market to you.  Assume they think you’ll buy $25 worth of books for the next 3 years, at a 20% gross margin, that’s $5 per year in gross profit, and at a 15% discount rate, that’s around $11 in expected value (which is greater than the $10 they spent to get your email in the first place).  Checkout the excel here.

Now, let’s apply the same logic to Facebook.  You’ll notice that I’ve put a 10 year horizon on the life of a Facebook user, and increased the discount rate to 25%, while also increasing the gross margin to 70%.  Hopefully that seems intuitive.

In order for Facebook to be worth $50 B, they would have to think that each of their users is worth (approximately) $50 B/ 500 mm users = $100 / user.  That means that the expected discounted gross profit from each customer has to be about 10x what a brick and mortar retailer would value an email address.  Again, checkout the excel here. And, if you believe that Facebook’s information is different from an email address in that it is about 100x deeper, and they can reach you much more effectively and frequently, then this makes sense.

What also makes sense is that Goldman Sachs is doing something smart with this $1.5 Billion offering – as they usually do with large sums of money.  They may be simply angling to take Facebook public and willing to invest at a high valuation for that reason.  But, they are probably also giving their best clients a chance to participate in what can potentially be one of the most successful IPOs of all time at a private company price.  And, with Groupon looking at a $15 Billion public valuation (per Goldman), it seems they have a close touch on the market for late stage tech deals.  And, the demand that exists is apparently overwhelming.

The bottom line is that Facebook is one of the few companies that represents a true platform capable of tackling many other businesses.  They certainly have the talent and infrastructure, but they also have the information and mind share in their users’ lives.  Think about what companies like Travel Zoo and Open Table (links are to “interesting” stock graphs) have been able to do recently due to adapting Groupon-like deals.  Think about the success that Yelp (article on adoption of their mobile checkin app) had launching their location based app.  These are “platform” companies capable of launching new and profitable business lines.  But, they pale in comparison to Facebook.  Think about Zynga building a multi billion dollar business mostly through Facebook.  This is the power of facebook and why it deserves that $50 Billion valuation, and why it will probably continue to increase in value.

A New Year – And there’s still snow on the ground

As a native New Englander, I enjoy a good snow storm.  It reminds me of building snow forts, skiing, snowmen, and trudging through snow into gyms packed with wrestling mats.  In fact, during our first major storm of the season, right after Christmas, you could find me wandering around SoHo in what others would call a blizzard, taking pictures of the largest drifts and plows moving all that wonderful white stuff around.

Surprisingly, New Yorkers were a bit nicer in the snow.  I saw 3 NYU students push a random car out of a snow bank.  A stranger said hello to me as I treked on through vacant streets that had been completely transformed by the storm.  And, it seemed that inside each window I passed, I saw people inside laughing and enjoying a Sunday evening.  Apparently going out for dinner/drinks during a blizzard is very chic these days.

Of course, there were still misfits in Washington Square Park – I saw two women playing in the snow wearing bikinis in the freezing weather.  And, the grinches of the world were grumbling as plows pushed snow onto the sidewalks and made them virtually impassable.  But, despite all this going on, there was a peaceful air as I walked through the streets that night almost a month and 3 snow storms ago.

I escaped to Aruba for the past 10 days with my family and am now back for another fun year in New York.  There is still snow on the ground, but I’m excited about what the next 12 months has to offer and where the “last year” the Mayan calendar will leave us :)….Happy belated New Year.

Some pictures of NYC from the first storm (clicking on them will actually give a much more viewable version):

Partial Liquidity in Response to Changes in the Capital Gains Tax Code

Many of the larger companies that I speak to are contemplating partial liquidity in 2010 before any potential changes to the capital gains tax code take effect.

The WSJ did a small article on this in last week’s Weekend Edition and I thought I’d run some numbers to see what makes sense when contemplating this decision (dividend taxes could more than double and it looks like long term capital gains will increase 33%).

The attached excel model (see the link below) should provide a working tool to customize this analysis to your own company.  Basically the decision comes down to taking money that is guaranteed and guaranteed to be taxed at a lower rate OR, letting it ride, continuing to grow the business, and keeping a greater equity stake for a larger liquidity event (M&A or IPO) down the line.

Obviously, if your business has Twitteresque growth, you should hang onto the equity for dear life!  But, especially given the relative stability of today’s markets and the relatively strong multiples deals are getting done at, it is worth exploring taking some “chips off the table” this Fall while still keeping a sizeable equity stake in your business to participate in the upside of an IPO or M&A exit.

Another scenario we’ve run into is non-operating partners who have large equity stakes and who may want to take money off the table now.  Especially in the case where these types of companies do not have a strong venture partner, it can make sense to allow those people to cash out, at least partially, in order to bring in a financial partner to help continue the growth of the business.

Below is the output of an NPV analysis on a very profitable and quickly growing business.  As you can see, taking some money off the table now makes sense given the assumptions of the model.  I highly suggest downloading and playing with the excel (see link below) to customize it to your business.

Some notes: I’ve basically assumed in scenario 1 that you sell 20% of your equity, continue to grow the business and then IPO in year 4 (2014).  In scenario 2, you keep all the equity, and IPO in 2014.  The cash flows in each scenario are discounted in order to take into account time value of money and also the probability of the business hitting a rough patch and not being able to deliver on projections.  In the excel, you may also want to take into account that partial liquidity/growth capital now could lead to the acceleration of your business if you find the right venture partner, and thus scenario 1 would become even more compelling.  Enjoy!

Cap Gain Taxes Analysis [Excel]