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Capital Solutions Newsletter…                                                                                                            download pdf
January, 2011

This month we examine why Facebook likes Goldman - and while not everyone wants to friend the happy couple, it's one heck of an interesting deal.  The best essays of the year discuss bond defaults, Greek monks, solitude, leadership, and wealth inequality; while the Kaufman Foundation weights in with an assortment of innovation criteria; entrepreneurs may be manipulative tax cheats, and our usual feature of five best blogs.

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Facebook "Friends" Goldman

The roughly $2 billion deal between Facebook and Goldman Sachs is so chock-rich of material it will surely spawn a series of longer pieces once it has settled into historical view.  To begin, it coincided with increased scrutiny by the SEC into secondary sales of private securities, particularly since one of the rumoured drivers of the deal was Facebook's desire to avoid the public financial reporting that would have been triggered once they reached 500 shareholders (which the Goldman deal neatly side-steps through a special purpose vehicle). And it reignited a debate on both the old boys network, and how a simple middleman can be so expensive (Goldman is taking a 4% commission on money placed, and a 5% commission on profits). And then Goldman yanked the offer for all U.S. clients.

The counter arguments: that the hype is precisely a sign that FB is now peaking, that a prestigious division of Goldman itself preferred not to invest, that FB is overvalued, a cautionary reminder of previous market leader MySpace's collapse, and even a comparison with similarly pitched Nigerian investment opportunities. 

Facebook has had 15 previous financings (graphically presented). But what makes this one so interesting is that Facebook has managed to structure a third path between traditional private firms and the full public markets. It now has less incentive for an eventual IPO, yet has proven access to all the capital it could ever covet, while giving employees a chance to cash in some of their paper wealth (and presumably slip right over to Goldman's wealth management group).

Frankly, it's a better ending than the movie, and I'm already hoping for a deal sequel.  

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Reading List: The Sidney Awards
 
The political commentator and writer David Books gives out annual Sidney Awards to the best magazine essays. All are wonderful, but three bear particularly interest for entrepreneurs and others with an interest in the capital markets.

First was "Beware of Greeks Bearing Bonds," by Michael Lewis and first published in Vanity Fair. Especially for anyone who has cursed the IRS and wondered what would happen should the US Government lose its ability to collect taxes -- well, be careful what you wish for.

Second is "Solitude and Leadership" by William Deresiewicz, which was initially a lecure at West Point, subsequently published in The American Scholar. Leadership, particularly of big institutions, often means having the courage to resist the conformity and routine that charcetize those institutions. Often, he says, this is learned through the ability to reflect - at exactly the same time we move to increased multitasking.  

Third is a piece on "The Inequality that Matters" by Tyler Cowen.  Cowen notes, what is now shared between different social classes is far greater than what is separated. Envy, as he points out, is usually local (with a wonderful quote attributed to Gore Vidal: "Whenever a friend succeeds, a little something in me dies"), yet the riches available exacerbate excessive risk-taking and cause substantial and dangerous implications for the economy.
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States of Invention
 
Research from the Kaufman Foundation looks for the areas of innovation across the US while publishing abroad New Economy Index. From the 2010 edition come a number of detailed statistics.  The top overall states will draw the most attention, yet more interesting are some of the smaller details. 

Here, then, are my top five categories (in no particular order) from the Kaufman report, and a listing of the top five states in each group.

• High-Wage Traded Services: Not a familiar category, this measures employment in traded service sectors where the average wage exceeds the national median -- in other words, who has the most high-end service jobs when one does not have to buy local. Top States: Delaware, Connecticut, New York, California, Minnesota. 

• Job Churning: If one believes in creative destruction, linger here. The category measures the combined number of new startups and business failures as a share of total state firms. Top States: Florida, Alaska, Idaho, Georgia, Colorado.
   
• Entrepreneurial Activity: More simply, the number of entrepreneurs starting new businesses. Top States: Georgia, Arizona, Montana, Florida, California.
   
• Inventor Patents: The number of independent patents per 1,000 residents.  Top States: Utah, Oregon, California, Massachusetts, Connecticut.
   
• Venture Capital: This measures venture capital invested in the state as a percentage of worker earnings.  Unsurprisingly, the top two states for VC, which captured over two-thirds of all venture investment in 2010, dominate - even when adjusted for populations and earnings. Top States: Massachusetts, California, Washington, Colorado, Utah.

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Entrepreneurs as tax dodgers

It's a little early for April Fools, and perhaps it is just my long exposure to entrepreneurs, but there is actually an argument circulating which labels entrepreneurs as tax cheats.  This is because entrepreneurs, when (and if) they realize gains on their equity, pay capital gains tax rates on the stock appreciation, instead of the higher rates used for ordinary income. These entrepreneurs, the theory goes, are shifting their pay from higher-tax-rate salaries to lower-tax-rate capital gains, cheating the IRS out of their due.

Now there are some considerable parallels to the carried interest debate (where fund principals pay lower tax rates than their assistants) but in this case I think intention is everything. Investment partnerships pursue a portfolio approach, limiting their risk (that is, risk above the often substantial management fees).  Entrepreneurs have all their eggs in a single basket, and particularly in the initial stages of any company, forgo market salaries out of necessity, not choice. And to attract capital most entrepreneurs need to display "aligned interests" with investors - salary below market and a substantial equity stake.  It's not a tax dodge; it would be a significant professional disadvantage for an entrepreneur to take a market salary.

However the corollary of this criticism posits an intriguing idea.  Imagine, for a moment, that one could get an equivalent tax write-off on the difference between a entrepreneur's salary and their market value.  The incentive for executives who lost their jobs to try starting their own business for a year or two (or at least the time it would take to find a new corporate suite) would be considerable.  And it would be blatantly and unethically manipulated, which, of course, is the opposite of what is happening when entrepreneurs take smaller salaries and large equity stakes.  

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Five Best Blogs

This month's list includes: The Early Failures of Famous Entrepreneurs, Rob Go on Startup Takeaways from 2010, a WSJ piece on What Is That VC Really Thinking During Your Pitch, Bryce Roberts on Everything will be reinvented, and Five Metrics every Software CEO should Obsess Over.

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Capital Solutions is sent irregularly, and generally not more than once each month.  All content and any errors are mine exclusively, while the occasional sharp insight is probably borrowed.  As always, feel free to contact me at the number below if you have any questions, or just to catch up.

 Regards,

 
Alexander Ooms | Managing Partner                      

alex@clearcreekpartners.com

303.731.2960