I guess this is goodbye

'I guess this is goodbye'; A behind-the-scenes look at Lehman Brothers' last gasp before bankruptc

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Canwest News Service

It is Sunday, Sept. 14, 2008, in New York and an intense weekend spent trying to prevent the collapse of Lehman Brothers and the market chaos that would cause was drawing to a close. There would be no white knight to rescue the company. This excerpt from Too Big to Fail by Andrew Ross Sorkin details the curtain call made to Lehman's board of directors.

Henry Paulson, Treasury Secretary, checked his watch and saw that it was past 7 p.m., which meant the Asian markets were opening, and Lehman still hadn't filed for bankruptcy.

"Has Cox talked to them yet?" he barked at his chief of staff, Jim Wilkinson.

Wilkinson said that he had been trying to get Chris Cox, chairman of the SEC, to call Lehman directly, but that he had been resistant.

"He hasn't done s?t," Wilkinson said dismissively. "I went in there and repeated what you said, and it's like he's frozen. Like a f?ing deer in the headlights."

Cox, for whom Paulson had very little respect to begin with, was proving how over his head he really was. Paulson had assigned him the task of co-ordinating Lehman's filing by, well, now. "This guy is useless," he said, throwing his hands in the air and heading over to Cox's temporary office himself.

After barging in and slamming the door, Paulson shouted, "What the hell are you doing? Why haven't you called them?"

Cox, who was clearly reticent about using his position in government to direct a company to file for bankruptcy, sheepishly offered that he wasn't certain if it was appropriate for him to make such a call.

"You guys are like the gang that can't shoot straight!" Paulson bellowed. "This is your f?ing job. You have to make the phone call."

The Lehman board had already begun its meeting when the bankruptcy lawyers from Weil Gotshal, towing wheeled suitcases stuffed with documents, finally arrived.

Then Richard Fuld's assistant came in and handed a slip of paper to her boss, who began to slump in his chair as he read it. "Chris Cox is calling and he wants to address us."

The board members looked at one another, their surprise etched in their expressions. No one could recall a time when the chairman of the SEC had asked to address a corporate board. One director questioned whether they should even take the call, but he was overruled. What did they have to lose? The lawyers, however, cautioned that if there were any questions, only the directors themselves should speak.

Fuld leaned in toward the speakerphone and said in a weary voice, "Ah, Chris, this is Dick Fuld. We got your message, and, ah, the board is in session here, everyone is here, all the directors and the firm's counsel."

A Lehman bankruptcy, Cox argued deliberately, stiffly, as if he were reading off a script, would help calm the market. It would be in the best interests of the nation, he said. He then introduced Tom Baxter, general counsel of the Federal Reserve of New York, who told the directors that the Fed and the SEC were in agreement that Lehman should file for bankruptcy.

One of Lehman's outside directors, Thomas Cruikshank, who had led the oil services company Halliburton through the 1980s oil bust before anointing Dick Cheney his successor as CEO, was the first to speak. "Why is it so important," he asked, with a slight air of umbrage, "for Lehman to be in bankruptcy?"

Cox repeated that the markets were in turmoil and that the government had taken everything into consideration. Others followed up with variations of that same query, but Cox and Baxter stayed on message. The directors grew increasingly and visibly frustrated by the vagueness of the two men's answers.

Finally, Cruikshank stated point-blank: "Let me see if I understand this. Are you directing us to put Lehman into bankruptcy?"

For several moments there was silence on the other end. Then Cox said, "Ah, give us a few moments, and we will get right to you."

After one of the lawyers reached over the table and pushed the mute button on the speakerphone, the Lehman directors erupted with questions. Is the SEC telling us to file? Is the Fed? What the hell is going on here?

To the best of anyone's knowledge, the government had never ordered a private firm to declare bankruptcy, essentially hanging the Going Out of Business sign on the door itself.

Ten minutes later, Cox, clearing his throat, got back on the line. "The decision on whether to file for bankruptcy protection is one that the board needs to make. It is not the government's decision," Cox said in the same steady, methodical tones. "But we believe that in your earlier meetings with the Fed, it was made quite clear what the preference of the government is…"

John Akers, the former chief executive of IBM, interrupted. "So you're not actually directing us?"

"I'm not saying anything more than what I just said," Cox replied before ending the conversation.

The directors looked around at one another dumbfounded as Fuld sat impassively, his head buried in his hands.

Tom Russo, Lehman's chief legal officer, stood and outlined the board's responsibilities under securities laws. As he spoke, some directors talked quietly among themselves. Bankruptcy seems inevitable. Do we file now? Next week? The government, they all knew, had plenty of leverage. If they did not do what Cox wanted, who knew what the consequences could be?

The Fed, which had agreed to lend money to Lehman's broker-dealer unit to allow it to fund trades, could just as easily close it and force Lehman into liquidation. There was a motion to vote on filing for bankruptcy.

Henry Kaufman, an 81-year-old former Salomon Brothers economist who headed the Lehman board's risk-management committee, haltingly stood up to speak. Known as "Dr. Doom" for his downbeat outlooks in the 1970s, Kaufman had been sharply critical of the Fed earlier in the year, accusing the central bank of "providing only tepid oversight of commercial banking." Now he again took aim at the government for pushing Lehman into bankruptcy.

"This is a day of disgrace! How could the government have allowed this to happen?" Kaufman thundered. "Where were the regulators?" He went on for another five minutes without stopping, and when he finally slumped into his seat, the other directors could only look on in sadness.

As midnight approached, the resolution to file was put to a vote and passed. Some of the directors had tears in their eyes. Fuld looked up and said, "Well, I guess this is goodbye."

One of the bankruptcy lawyers, Lori Fife, laughed. "Oh, no. You're not going anyplace," she said. "The board will be playing a pivotal role going forward."

Miller elaborated on her point: "You're going to have to decide what to do with these assets. So it's not goodbye. We're going to be seeing each other for a while."

Fuld looked at the lawyers for a moment, dazed. "Oh, really?" he said softly, and then slowly walked out of the room, alone.

Warren Buffett, just back in Omaha from Edmonton, had received word of Lehman's pending bankruptcy before he arrived at the Happy Hollow Country Club for a late dinner with Sergey Brin, the co-founder of Google, and his wife, Ann.

"You may have saved me a lot of money," he said to the Brins with a laugh in the grand dining room. "If it wasn't for getting here on time, I might have bought something."

Mayor Michael Bloomberg, who had been on the phone with Paulson, called Kevin Sheekey, his deputy mayor for government affairs, from his brownstone. "I think we have to cancel our trip to California," he told Sheekey, who was already packing his bags for a high-profile event with Governor Arnold Schwarzenegger that he had been planning for months.

"The world is about to end tomorrow," Bloomberg explained, without a hint of sarcasm.

"Are you sure you want to be in New York for that?" Sheekey deadpanned.

Peter G. Peterson, co-founder of the private-equity firm Blackstone Group and the CEO of Lehman in the 1970s before being ousted by Glucksman, was watching television with his wife, Joan Ganz Cooney, when she passed him the phone. It was a New York Times reporter asking him to comment on the day's events.

After pausing for a moment to take it all in, he said: "My goodness. I've been in the business 35 years, and these are the most extraordinary events I've ever seen."

Christian Lawless, a senior vice-president in Lehman's European mortgage operation in London, still at the office, emailed his clients Sunday night with a final sign-off : "Words cannot express the sadness in the franchise that has been destroyed over the last few weeks, but I wanted to assure you that we will reappear in one form or another, stronger than ever." ? Reprinted by arrangement with Viking Penguin, a member of Penguin Group (USA) Inc., from Too Big to Fail by Andrew Ross Sorkin.

Silicon Valley Is Not Wall Street

FEBRUARY 25, 2010
By TOM PERKINS

Too often, there is confusion between investment banking and venture capital. This isn't helped by investment bankers' occasional assertions that they too do venture capital. They don't. In light of the attention both of these activities have lately received in Washington, it seems a perfect time to explain what makes them so very different.

Venture capitalists work with entrepreneurs to start new companies from the ground up. We earn our reward only when companies become successful.

Investment bankers are deal makers. They're in charge of bringing companies public and advising on acquisitions. Their money is earned by the transaction, and in the fraction of the time it takes a venture capitalist to realize a profit.

Whereas Wall Street has been the source of what feels like endless scandals and financial catastrophes, venture capital has created jobs, jobs, and more jobs of the highest caliber. It's no surprise that Silicon Valley's Sand Hill Road in Menlo Park has been the locus of our national high tech activity and the envy of the world, while Wall Street is secure in its reputation as the planet's frequent scourge.

The facts speak for themselves. Approximately 11%, or 12.1 million, of private-sector jobs reside at companies that were founded with venture capital. These companies include Intel, Genentech, Google, FedEx and Starbucks. Another 500,000 jobs are currently housed in newer start-up companies that are still privately held, and are poised to grow exponentially over the next decade.

In 2009, a year with nearly universal shrinkage in employment, 35,000 new jobs were posted on the job board StartUpHire.com, all created by companies backed by venture capital. This job creation has occurred in every one of the 50 states. Wall Street's share? Zip, zero, nada.

Yet the politicians on Capitol Hill don't seem to recognize these differences. Venture capital is constantly at risk of being swept up in federal tax and regulatory initiatives aimed at curbing Wall Street's abuses.

Last year our industry was originally included in new SEC rules aimed at hedge funds and other sources of systemic risk. But the managers of venture capital firms, usually partnerships, are not risking capital raised from the general public or guaranteed by the federal government. They are not financial advisers in any sense of the term.

But the default mode in Washington is to regulate broadly, without regard for unintended consequences. Thankfully, Congress listened to our concerns and ultimately exempted venture capital from these rules. Still, it was an arduous process to help them understand who we are. That process continues.

Our industry is a very patient one. We invest over the long term, striving for capital gains. And we invest continuously in bull and bear markets.

As Wall Street came to a screeching halt in 2009, our industry nevertheless invested more than $17 billion in emerging companies. Many of those companies will take a decade or more to mature. It would be killing the golden goose to tax venture capitalists as if they were hedge fund or investment banking casino operators.

How has our industry been able to keep its skirts so clean and continue to serve as our country's economic engine? Why is it so unlike the age-old crash-and-burn pattern of Wall Street? I think the answer goes back to venture capital's earliest days in Silicon Valley (before the name of that place had even been coined). The first practitioners, including Eugene Kleiner and me, had familiarity with Wall Street operators and we set up our partnerships to avoid specifically problematic practices.

These parameters included: no leverage; audited statements; never investing personal capital where the partnership could or should do so (that is, no "cherry picking" at the investors expense); no profit participation until the investor's entire capital had been repaid; limited partnership life and no investments of new capital in older deals. These early ideas have become nearly universal over the decades. And in my opinion, they have kept our industry healthy, profitable and largely scandal-free.

It is time the venture industry is rewarded for the work that we do and how we go about doing it. We are not asking for bailout money or additional tax breaks. We simply want those in the Beltway to leave us alone and let us do our jobs -- which means creating more jobs for our country.

Mr. Perkins is a former president of the National Venture Capital Association, a partner emeritus of Kleiner Perkins Caufield & Byers, and author of "Valley Boy: The Education of Tom Perkins" (Gotham, 2007). He is a director of News Corporation.

Turning Patents Into ‘Invention Capital’

February 18, 2010
Turning Patents Into ‘Invention Capital’
By STEVE LOHR

BELLEVUE, Wash. — Nathan Myhrvold wants to shake up the marketplace for ideas. His mission and the activities of the company he heads, Intellectual Ventures, a secretive $5 billion investment firm that has scooped up 30,000 patents, inspire admiration and angst.

Admirers of Mr. Myhrvold, the scientist who led Microsoft’s technology development in the 1990s, see an innovator seeking to elevate the economic role and financial rewards for inventors whose patented ideas are often used without compensation by big technology companies. His detractors see a cynical operator deploying his bulging patent trove as a powerful bargaining chip, along with the implied threat of costly litigation, to prod high-tech companies to pay him lucrative fees. They call his company “Intellectual Vultures.”

White hat or black hat, Intellectual Ventures is growing rapidly and becoming a major force in the marketplace for intellectual capital. Its rise comes as Congress is considering legislation, championed by large technology companies, that would make it more difficult for patent holders to win large damage awards in court — changes that Mr. Myhrvold has opposed in Congressional testimony and that his company has lobbied against.

Intellectual Ventures spent more than $1 million on lobbying last year, according to public filings compiled by OpenSecrets.org. In the three most recent election cycles — 2006, 2008 and 2010 — Intellectual Ventures executives, led by Mr. Myhrvold, have contributed more than $1 million to Democratic and Republican candidates and committees.

Mr. Myhrvold makes no apology for playing hard under the current patent system. If his company is going to help change things, it must be a force to be reckoned with. “We have to be successful,” he said.

The issues surrounding Intellectual Ventures, viewed broadly, are the ground rules and incentives for innovation. “How this plays out will be crucial to the American economy,” said Josh Lerner, an economist and patent expert at the Harvard Business School.

Mr. Myhrvold certainly thinks so. He says he is trying to build a robust, efficient market for “invention capital,” much as private equity and venture capital developed in recent decades. “They started from nothing, were deeply misunderstood and were trashed by people threatened by new business models,” he said in his offices here.

Mr. Myhrvold presents his case at length in a 7,000-word article published on Thursday in the Harvard Business Review. “If we and firms like us succeed,” he writes, “the invention capital system will turbocharge technological progress, create many more new businesses, and change the world for the better.”

In the article and in conversation, Mr. Myhrvold describes the patent world as a vastly underdeveloped market, starved for private capital and too dependent on federal financing for universities and government agencies, which is mainly aimed at scientific discovery anyway. Eventually, he foresees patents being valued as a separate asset class, like real estate or securities.

His antagonists, he says, are the “cozy oligarchy” of big technology companies like I.B.M., Hewlett-Packard and others that typically reach cross-licensing agreements with each other, and then refuse to deal with or acknowledge the work of inventors or smaller companies.

Ignoring the patents of others is “deeply ingrained in parts of certain industries,” he writes in the article, “most notably software, computing and other Internet-related sectors.”

Large technology companies complain about patent suits but, Mr. Myhrvold says, their actions often invite litigation. “The attitude of the big guys has been that unless you sue me or threaten to sue me, get lost,” he said in the interview. “I know, I was one of those guys.” Indeed, Mr. Myhrvold, 50, supplied his considerable brain power to Microsoft for 13 years, serving as chief technology officer until 2000.

Mr. Myhrvold personifies the term polymath. He is a prolific patent producer himself, with more than 100 held or applied for. He earned his Ph.D. in physics from Princeton and did postdoctorate research on quantum field theory under Stephen Hawking, before founding a start-up that Microsoft acquired.

He is an accomplished French chef, who has also won a national barbecue contest in Tennessee. He is an avid wildlife photographer, and he has dabbled in paleontology, working on research projects digging for dinosaur remains in the Rockies.

His Intellectual Ventures is not simply a patent hedge fund. Its 650 employees include scientists and engineers, and it has an in-house invention effort and lab that last year applied for 450 patents. To date, the company has paid $315 million to individual inventors.

He calls patents “the next software,” noting that software did not become a market on its own until the 1980s, spurred by innovators and the enforcement of intellectual property laws. “I’m trying to get inventions that kind of respect as an economic entity,” he said.

Yet while Mr. Myhrvold is saying one thing, his company’s main activity is quite another, according to Mark Bohannon, general counsel and senior vice president for public policy for the Software and Information Industry Association.

Intellectual Ventures, Mr. Bohannon says, is the largest of the category of firms that hold patents, but do not make products. Lawyers call such firms nonpracticing entities, NPEs, though they are often labeled as patent trolls. “Our concern is that it games the patent litigation system so it can extract licensing fees and investments from technology companies that create jobs, innovate and make products,” said Mr. Bohannon, whose trade association includes I.B.M., Google, Oracle, SAP and Adobe.

Several analysts say that Intellectual Ventures has been primarily a master practitioner of exploiting the current rules of the game to its advantage. Many companies in the patent field use shell companies to mask their activities, and Intellectual Ventures seems to employ them with uncommon frequency. A report last month by Avancept, an intellectual property consulting firm, said that up to 1,110 shell companies and affiliated entities appear to be linked to Intellectual Ventures. The secrecy, said Thomas Ewing, principal consultant for Avancept, makes it “far more difficult to confidently negotiate with Intellectual Ventures.”

Intellectual Ventures, founded in 2000, began operating in 2003. It says it has returned $1 billion to investors and collected more than $1 billion in license fees to date. Most of the revenue has apparently come from 16 so-called strategic investors — big companies that pay to license patent rights and get a stake in an Intellectual Ventures fund.

The companies must sign strict nondisclosure agreements to even talk with Intellectual Ventures. Only Microsoft has publicly stated that it is one of the group. In 2008, The Wall Street Journal reported that Verizon Communications had agreed to pay Intellectual Ventures $350 million. Other companies that have agreed to sizable payments to Intellectual Ventures include Intel, Nokia and Sony, according to people told of deals. And Intellectual Ventures has sought deals with others, including I.B.M. and Amazon, so far without success, say people informed of the talks.

Intellectual Ventures’ penchant for secrecy, Mr. Myhrvold says, is partly a legacy from its early days as an upstart when it did not want to tip its hand. Personally, he says he advocates not only the public disclosure of patents but also license agreements, but he will not give up the competitive edge of secrecy unilaterally. “If everybody in the industry does it, I’ll be right there,” Mr. Myhrvold said.

Amherst Holdings of Austin

A Daring Trade Has Wall Street Seething

Texas Brokerage Firm Outwits the Big Banks in a Mortgage-Related Deal, and Now It's War

By GREGORY ZUCKERMAN, SERENA NG and LIZ RAPPAPORT
A canny trade by a small brokerage firm in two markets at the heart of the financial crisis has left some of the biggest players on Wall Street crying foul.

The trade, by Amherst Holdings of Austin, Texas, was particularly galling to the big banks because it turned what they believed was a sure-fire profit into a loss.

The burned banks include J.P. Morgan Chase & Co., Royal Bank of Scotland Group PLC and Bank of America Corp. Some banks have reached out to two industry trade groups about Amherst's actions, and the groups are reviewing the transaction, according to people familiar with their thinking. "It's all-out warfare" between the banks and Amherst, said a senior banker at one firm that lost money.

At issue is a move by Amherst to boost the price of bonds to avoid paying out on credit-default swaps it had sold. Banks are questioning whether Amherst set them up by selling credit-default swaps and then rendering them worthless.

Amherst says it didn't do anything improper, but took advantage of an opportunity when it emerged. A lawyer reviewed and blessed the strategy for the firm, according to people familiar with the matter.

Privately held Amherst says it acted in good faith trying to limit losses for clients, who had sold credit-default swaps on the securities. "We wouldn't jeopardize our business and reputation by entering into an opportunistic trade knowing what the outcome would be," said Amherst's chief executive, Sean Dobson.

The dispute echoes battles over the largely unregulated credit-default-swap market during last year's financial turmoil. Companies including Morgan Stanley accused investors of using the insurance-like contracts to hurt the value of their shares, creating a panic among other investors and the firms' clients.

In 2007, a group of hedge funds led by Paulson & Co. suspected Bear Stearns of plotting to boost the value of subprime-mortgage securities. At the time, Bear (which was later bought by J.P. Morgan) denied planning to engage in such transactions.

So far the latest dust-up has been all words, in part, bankers say, because they are wary of attracting more regulatory scrutiny at a time when lawmakers are planning major reforms in the largely unregulated derivatives markets, long lucrative for banks. While the banks' combined losses from the trade were in the tens of millions of dollars -- modest by recent standards -- they are the buzz of Wall Street as firms try to prevent a repeat of the episode.

The trade involved credit-default swaps and securities backed by subprime mortgages. The original securities had been sold by Lehman Brothers and were backed by $335 million of subprime mortgages mostly on homes in California made at the housing bubble's peak in 2005, according to the prospectus.

Following a wave of refinancing and defaults, only $29 million of the loans were left outstanding by March 2009, half of which were delinquent or in default, according to a performance report by Moody's Investors Service.

Believing the securities would become worthless, traders at J.P. Morgan bought credit-default swaps over the past year from Amherst, according to people familiar with the matter. Credit-default swaps act like insurance, paying off the buyer if securities are hit by losses. Other banks including RBS Securities, which is the U.S. investment-banking arm of Royal Bank of Scotland, and BofA also bought swaps on the securities from different trading partners.

The banks had to pay up for the protection, similar to a person buying insurance on a beach house just before a hurricane. They paid as much as 80 to 90 cents for every dollar of insurance, the going rate last fall according to dealer quotes, expecting to receive a dollar back when the securities became worthless over the coming months.

Traders can buy credit-default swaps on securities they don't own. At one point, at least $130 million of bets had been made on the performance of around $27 million in securities, according to a person familiar with the matter.

In late April, traders at some banks were shocked to find out from monthly remittance reports that the bonds they had bet against had been paid off in full. Normally an investor can't pay off loans like that but if the amount of outstanding loans falls to less than 10% of the original pool, the servicer -- or company that collects mortgage payments from homeowners and forwards them to investors who own the securities -- can buy them and make bondholders whole.

That's what happened in this case. In April, a servicer called Aurora Loan Services at the behest of Amherst purchased the remaining loans and paid off the bonds.

Although Amherst won't provide specifics and won't comment on its arrangement with Aurora, it doesn't deny that it took this approach. (Aurora says it is a subsidiary of Lehman Brothers Bank, but not part of the Lehman Brothers Holdings bankruptcy filing.)

A spokeswoman for Aurora says these servicer provisions are customary and when rights are exercised it ensures that appropriate requirements are met.

When the bonds got paid off, the swaps became worthless, meaning the banks effectively forfeited what they had paid for the insurance. J.P. Morgan lost millions, while RBS and BofA suffered minimal losses, said people familiar with the matter.

On April 28 representatives of banks including J.P. Morgan, Goldman Sachs Group Inc. and UBS AG's UBS Securities held a conference call to discuss the trade but didn't come to any conclusion, according to people familiar with the matter.

Amherst is the antithesis of the big Wall Street banks. With its Austin headquarters and around 100 employees, the 15-year-old firm has long been a player in the mortgage market, but is now one of the upstarts trying to take business from banks weakened by the credit crisis. The firms has hired bankers, mortgage traders and research analysts who had left banks such as Bear Stearns and UBS, while raising new capital to expand its trading activities.

Since the mortgage securities were valued at just $3 million or so in the market, well below the $27 million they were redeemed for, traders believe Amherst entered into an uneconomic transaction to profit from its swap positions.

Firms that suffered losses as well as some that didn't have brought the trade to the attention of two financial industry groups, the Securities Industry and Financial Markets Association, and the American Securitization Forum, which are considering their concerns, say people familiar with the trade groups' thinking.

Critics of these markets say such conflicts aren't a surprise. In secretive, over-the-counter markets "there are hidden risks and fault lines that don't show up until times of stress or when people are losing money," says Martin Weiss of Weiss Research, an investment consultancy in Jupiter, Fla., not involved in the trade.

Many credit-default swap contracts that were written on subprime mortgage securities over the past three years remain outstanding, and holders could lose out if more bonds are made whole. Deutsche Bank has sent a list, reviewed by The Wall Street Journal, to its clients of more than two dozen other mortgage pools that could see similar moves.

Write to Gregory Zuckerman at gregory.zuckerman@wsj.com, Serena Ng at serena.ng@wsj.com and Liz Rappaport at liz.rappaport@wsj.com

No Empty Threat: CDSs and bankruptcy

No empty threat
Jun 18th 2009
From The Economist print edition


Credit-default swaps are pitting firms against their own creditors
SIX FLAGS, an American theme-park operator, filed for Chapter 11 bankruptcy protection on June 13th, bringing its long ride to reduce debt obligations to an abrupt halt. The surprise was that bondholders, not the tepid credit markets, stymied the restructuring effort. Bankruptcy codes assume that creditors always attempt to keep solvent firms out of bankruptcy. Six Flags and others are finding that financial innovation has undermined that premise.

Pragmatic lenders who hedged their economic exposure through credit-default swaps (CDSs), a type of insurance against default, can often make higher returns from CDS payouts than from out-of-court restructuring plans. In the case of Six Flags, fingers are pointing at a Fidelity mutual fund for turning down an offer that would have granted unsecured creditors an 85% equity stake. Mike Simonton, an analyst at Fitch, a ratings agency, calculates that uninsured bondholders will receive less than 10% of the equity now that Six Flags has filed for protection.

Some investors take an even more predatory approach. By purchasing a material amount of a firm’s debt in conjunction with a disproportionately large number of CDS contracts, rapacious lenders (mostly hedge funds) can render bankruptcy more attractive than solvency.

Getty Images

Downhill from here

Henry Hu of the University of Texas calls this phenomenon the “empty creditor” problem. About two years ago Mr Hu began noticing odd behaviour in bankruptcy proceedings—one bemused courtroom witnessed a junior creditor argue that the valuation placed on a firm was too high. With default rates climbing, he sees such perverse incentives as a looming threat to financial stability. Already the bankruptcies of AbitibiBowater, a paper manufacturer, and General Growth Properties, a property investor, in mid-April have been blamed on bondholders with unusual economic exposures. Some also suspect that CDS contracts played a role in General Motors’ filing earlier this month.

Solutions to the problem are, so far, purely theoretical. One option would be regulation requiring disclosure by investors of all credit-linked positions. There is now almost no disclosure of who owns derivatives on a company’s debt, leaving firms to guess how amenable creditors will be when approached with a restructuring plan. Longer-term solutions rest on an overhaul of the bankruptcy code and debt agreements to award votes and control based on net economic exposure, rather than the nominal amount of debt owned. Supporters of the market point to the value of CDSs in reducing the cost of capital and to plans for a central clearing house that will reduce redundancy and increase transparency. But the reform roller-coaster has not yet come to a halt.

Do Internet Start-Ups Really Need Venture Capital?

http://blogs.wsj.com/venturecapital/2009/07/23/do-internet-start-ups-really-need-venture-capital/tab/print/

JULY 23, 2009, 2:48 PM ET

With software-development tools readily available – and with seemingly insatiable demand among consumers for easy-to-use applications for smartphones – it continues to be easier, and cheaper, to start up an Internet or software business.

Fotki.com, a profitable photo-sharing site with 1.4 million members, built without venture capital

At the same time, global financial troubles have made it harder than ever for new companies to get funding from venture capitalists – who are, in turn, having trouble raising money from their limited partners.

This good-news-bad-news scenario for entrepreneurs has prompted some to ask the question: Do these start-up companies still need venture capitalists?

“VCs and founders are like two components that used to be bolted together. Around 2000, the bolt was removed,” wrote Paul Graham, a partner at start-up incubator Y Combinator in a December 2008 blog post.

“A sharp impact would make them fly apart. And the present recession could be that impact,” Graham wrote.

Indeed, strains are beginning to show in the relationship between founders and VCs as money problems loom.

At a recent tech-industry gathering in San Francisco, investors from top-tier firms Accel Partners and First Round Capital reminded a room full of entrepreneurs that there’s a lot more to the founder-VC relationship than money. Investors help company founders refine their vision, generate buzz and bring their products to market, and they should be seen as teammates, VCs said.

But this rosy picture was quickly debunked by serial entrepreneur Jonathan Abrams, founder of early social network Friendster Inc. and event-planning site Socializr Inc.

“Believing these conventional wisdoms cost me a lot of money in the past,” he said. “The real world is a lot less pretty than that utopian VC fantasy.”

At Friendster - which raised more than $20 million in venture funding from top firms like Kleiner Perkins Caufield & Byers, Battery Ventures and Benchmark Capital - Abrams was replaced as CEO as the site experienced technical problems, eventually losing ground to rivals like MySpace.

It’s a different world today, as cloud computing, software-development kits and other advancements have made it easier to start a software or Web-based business with a credit card or friends-and-family capital.

Entrepreneurs are looking at companies like Fotki.com, a Russian photo-sharing site that has been self-funded and profitable since 1998. The company is seen as a pioneer by many in the industry, as it created a working photo-sharing site long before the well-known players of today like Flickr and Photobucket.

Fotki has grown its user base to 1.4 million members – mostly in Russia — without taking a dime in venture capital.

But Igor Shoifot, Fotki’s CEO, cautions against reading too much into what his company has done.

“Once you build a theory around this, you start disregarding a lot of the truth,” he said. “This is not one-size-fits all.”

Young companies, by and large, need venture capitalists as much as they ever did, Shoifot said. While it might be possible to launch on very little, it’s hard to shine without some big names behind you, he said.

“Just look at Twitter,” he said. “And look at all the other micro-blogging companies out there. No offense to Twitter, but what’s the difference between Twitter and all these other micro-blogs? About $20 million in venture capital.”

For more perspective on this topic, we recommend reading the following blog posts:

- Web 2.0 Is A Gift, Not A Threat, To VCs (Dec. 21, 2006) - Fred Wilson of venture firm Union Square Ventures, an investor in Twitter and other Web 2.0 start-ups, writes that while you can build and launch a Web service in less than a year for less than $600,000, it costs a lot more money to “maintain it, develop it from there, deal with scalability, deal with feature enhancements, take the service in new directions, respond to competitive threats,” hire more engineers and support customer service.

-Don’t Raise Venture Capital (Sept. 26, 2008) - Healy Jones, then an associate at venture firm Atlas Venture, illustrates why most start-ups, especially in the Web 2.0 space, don’t need to raise venture capital.

-7 Great Reasons Why Not To Take Venture Capital (May 27, 2009) - Greg Gianforte, CEO of publicly traded RightNow Technologies and a serial entrepreneur, offers seven reasons why most start-up founders should avoid raising venture capital, at least in the beginning. Gianforte, who built two companies including RightNow on a no-frills bootstrap philosophy, wrote a book on the subject in 2005, at which time he detailed to us why bootstrapping is the way to go.

- My Startup Experience (June 28, 2009) - Rand Fishkin, a co-founder of venture-backed SEOMoz, makes a convincing case for taking outside capital. He discloses a wealth of information about his business and uses several charts and metrics to illustrate his points.

What Venture Capital Can Learn from Private Equity

What Venture Capital Can Learn from Private Equity

The venture capital game has changed, yet many VCs are still using an old, outdated playbook

By Peter Rip

Business Week

updated 8:00 p.m. ET April 15, 2009

Baseball and venture capital always seem to make an effective pairing for analogies. As in baseball, much of the cachet of venture capital is inspired by the romance of the metaphoric grand slam. The recipe has been the same since venture capital began: Find a team, give it money, sit back, and wait for the bloom. Most investments fail. But a few could be big winners and make it all turn out just fine. It used to be said in this business: "You can only lose one times your money." The implication is that winners will pay back the risk many times over.

The reality is that this approach works for an ever-winnowing number of companies, and shockingly few since 2000. The median venture capital fund has seriously underperformed the Russell 2000 Index since 2000. This is a stunning reversal over the prior two decades. What happened? There was a structural change in the game, yet most of the incumbents kept executing the same playbook.

Traditionally that has meant funding disruptive change and managing execution risk. For example, the decision by Kleiner Perkins Caufield & Byers to recruit Eric Schmidt was a masterful way to take the risk out of business execution at Google (GOOG) early on. Closer to my home, my partner, Jim Feuille, led change in our business model when we invested in Pandora Media, changing from a subscription service to free personalized Internet radio. Today, Pandora is the largest radio site on the Web. Managing execution risk at Pandora meant adding measured risk to capture the return of a bigger opportunity.

The classic VC play has always been to take enough risks and you'll be rewarded with the Great Exit, such as a big IPO or acquisition. VCs learned to excel at team selection and the mitigation of execution risk, often considering other risks inherently uncontrollable. Venture capitalists tended to place less emphasis on issues such as valuation, the timing of exits, and future capital availability precisely because you could only lose one times your money.

The Bull Benefit

Great Exits happened from 1982 to 2000 with a regular cadence. The strategy of going for the grand slam in every deal in every portfolio worked often enough during that bull market. The bull market gave public companies more currency to buy startups and often instilled public investors with confidence in the future of small growth companies. There were some spectacular successes among many long-forgotten failures.

The bull market in technology ended with a bang in 2000. Nevertheless, most of the venture capital industry still executes the same playbook, ignoring the public market, which is why the industry has performed so poorly since 2000.

Author Michael Lewis chronicled the success of baseball teams such as the 2002 Oakland Athletics in his book Moneyball. The A's didn't have the funds to buy top athletes, but instead assembled a winning team through a more analytical approach. Statistical analyses included in the book found that ballclubs that simply tried to get a man on base as many times as possible won more games than teams that focused on hitting home runs.

Most investors in venture capital understand that you cannot generate an acceptable rate of return by hitting singles and doubles. What they don't appreciate is that a strikeout is far more destructive when grand slams are fewer and further between. And with fewer grand slams, time also matters. In a secular bear market, that Great Exit may take so long to occur that the drought destroys your internal rate of return.

More Risk to Manage

In short, it has become clear since 2000 that financial risk/return is as important as execution risk in venture capital. Financial risk/return refers to weighing the risk that the financial markets may not be ripe enough soon enough to justify investing this much, at this valuation, now. Today's VCs have to pick great markets, great teams, and manage execution risk, as they always did. But they also have to manage valuation risk, timing risk, and investor syndicate risk.

Venture capitalists can learn a lot about managing this new set of risks from their counterparts in private equity. Whereas the traditional venture capital playbook has been about company-building, the private equity playbook has been about financial engineering. Private equity is focused on metrics, comparables, terms, and cost of capital -- more so than innovation, market selection, and team development. Their teams and companies are more mature, reducing the need to be an expert in assessing execution risk.

Think about this in terms of an inflection point, or that period when an additional dollar invested yields far greater shareholder value than it would have at an earlier phase. It's the point at which a little gas fuels a huge fire. Finding the best companies and investing in them at inflection points are perhaps their two most important disciplines. Stage is not a consideration. It is all about that inflection point.

Venture capital is at the intersection of innovation and finance. Fortunately for investors, innovation continues without regard for the financial markets. The jet engine, the helicopter, FM broadcasting, fiberglass, nylon, photocopying, radar, sticky tape, and instant film were all invented during the Great Depression. Breakthroughs are everywhere today, in energy technology, biotechnology, and even information technology. These innovations will continue to disrupt incumbents and create new markets -- and they will all need early-stage venture capital.

But the absence of buoyancy in capital markets means the early bet is not always the best bet. The new venture capital playbook begins by taking into account the macro drivers of growth. Which sectors are most ripe for disruption through innovation? Add to this the venture practice of building networks of entrepreneurs and partners who can place you in the flow of that innovation.

Inflection Points

Here's where the private equity model takes hold. Like private equity investors, VCs need to understand the entire sector, at every stage in the spectrum -- seedlings through large public companies -- to develop a theory of how the industry will evolve. Who will win and who will lose? When will incumbents need to make strategic acquisitions? What events have to transpire to enable big, new markets?

And, like other forms of private equity, the timing and probability of exits are as critical as their magnitude. This necessarily leads to a view toward finding inflection points, regardless of stage. Sometimes the best stage is the napkin sketch in the coffee shop; sometimes it's the phoenix rising from the ashes of $100 milllion of previous investors' capital. Either has the potential for venture capital success. The best performing venture capital investors will be able to find both.

At Crosslink Capital we have been evolving this new venture capital playbook since the late 1990s. We recognized early on that the bull market was over in 2000. We mostly sat on the sidelines for much of 2001 and 2002 with our 2000 venture fund. When we did return to investing, we did many restarts, turnarounds, and private investments in recently public companies, many of which were in Internet and services. This strategy of selectivity, stage independence, and a focus on companies at inflection has served us well.

Letting Go of the IPO Window

By 2006 we began to see two important shifts with our new venture fund. One was the emergence of energy technology as a new and important growth market opportunity. Many energy technologies had reached a point where the scientific risk was being replaced with commercialization risk. This transition is always a tipping point in the emergence of new growth venture markets.

The other shift was a rising inflation in later-stage valuations. It seemed many of our peers anticipated a forthcoming IPO window, whereas we did not. So we tended to find better values in earlier-stage opportunities, where the return multiples would justify the higher financial and execution risk. A few of these companies have had very attractive subsequent financings, suggesting we are off to a very good start. Among the companies funded were Twin Creeks Technologies [energy], Like.com [search], and OpSource [cloud computing].

There are lots of strategies for playing to win in baseball and in venture capital. The best strategies are context-specific. Entrepreneurship and innovation are eternal. A few venture firms will be able to continue to successfully swing for the fences without the bull market tailwind. Most will not. Great returns will continue in venture capital, but only for those who can successfully operate across the spectrum of private companies and find great value regardless of their stage.

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