the paradox of diversification

I read an entry on Fred Wilson’s blog on The Power Of Diversification. I don’t disagree with anything in his column, or the earlier one he links to where he describes basic portfolio theory. But the concept of diversification has always puzzled me a bit. Taken to it’s conclusion, portfolio theory suggests that optimal investment is one that is extremely diversified across all investments – i.e. the market portfolio. That’s often the reason given to invest in market index funds (though optimally diversification should be across asset types that may not be reflected or inadequately reflected in market indices – e.g. bonds, real estate, precious metals, etc.). This is because diversification reduces the impact of company or investee specific risk. Going further, if one diversifies more broadly, you eliminate industry specific risk, geographic specific risk, and so on. Therefore, the optimal investment strategy to maximize your return for any given level of risk is to invest only in the market portfolio, then leverage or deleverage to meet your personal risk tolerance. I’m probably not explaining it all too well – try Wikipedia for a more detailed and better written explanation.

Diversification can be quite a powerful tool. In fact, in certain (rather limited) circumstances, it can even change two losing prospects into a winner, so long as you alternate between the two. Not really the subject of what I wanted to chat about today – you can read more about Parrondo’s Paradox in this NYT archive or on io9. Or just google it.

Anyway, the mention of paradox is fortuitous. I don’t necessarily know if it’s the right term for what I’m about to describe, or whether it really does precisely fit within the definition of paradox. Nonetheless, to me, it seems that advice on diversification seems somewhat paradoxical. And by that, I mean that if you follow the logical conclusion of the lesson taught by modern portfolio theory on diversification, then it doesn’t really make much sense for anyone to specialize say, for example, in early stage technology companies. The greater the departure from the market or efficient frontier portfolio, the less optimal the risk/return ratio. And yet, despite this, there are many, many specialists that take a narrow focus (despite their diversification amongst investee companies), just like Union Square Ventures, who often do quite well, even though portfolio theory suggests that all specialists are using sub-optimal strategies exposing them to more risk than they need to be exposed to for a given return.

I suppose the same could be said of  entrepreneurs who, very often, put all their eggs into one basket – and, to address a point made by Fred Wilson, this is even after they’ve succeeded and accumulated a great deal of wealth. Elon Musk may be a good example of that. I think (but don’t know with certainty) that most of his wealth is invested in two, and only two, highly risky and focused ventures (being Tesla Motors and SpaceX).

Moreover, it would seem to me that if everyone in the world pursued the optimal diversification strategy as suggested by portfolio theory, including, for example, all narrowly focused or industry specific venture capital funds, then the diversity of assets (and possibly asset classes) would, I think diminish. Sort of like the paradox of efficient markets, I suppose.

But who knows. I don’t pretend to be an expert in modern portfolio theory. Would be interested in hearing from those more knowledgeable in the area.

standardized seed financing docs for canucks

Some of my loyal readers may recall one of my posts earlier this year about the development of standardized seed financing docs in the US, where there were, at the time, about four different sets of docs which had been developed. It pointed to a more detailed article by Brad Feld. In any event, I had asked the question whether anyone was aware of a similar initiative in Canada but didn’t hear from anyone. Was actually going to try doing it myself, but free work that you give away sometimes goes quickly to the back burner (or rather off the stove altogether) when things get busy. Least that’s my excuse.

In any event, I was very happy to hear that someone in Canada has in fact undertaken this initiative. The folks at MaRS here in Toronto, and in particular Mark Zimmerman, have apparently developed a nice set of Canadianized templates, including a term sheet (.doc) a subscription agreement (.doc), articles of amendment (.doc) and a shareholders’ agreement (.doc), with a founder’s agreement and employment agreement in the work. They already have a template independent contractor agreement (.doc).

I haven’t had a chance to look at them, but if you happen to need a set of seed round docs, and you’re here in the great white north, I’d encourage you to check them out. The folks at MaRS deserve a pat on the back for taking the initiative.

Tip o’ the fedora to Jonathan Polak for bringing this to my attention.

fusenet’s employment/entrepreneur program

A very interesting story in IT World Canada about a company called Fusenet that has put into place a novel approach to business. In effect, it is empowering its employees to become entrepreneurs and giving them equity in their creations. Fascinating approach. Inevitably comparisons can be drawn with a similar program Google runs, but as far as I’m aware Google retains ownership of everything created by its employees. Not so with Fusenet’s model. From the article:

Every Friday, the Pet Project Program (P3) goes into effect. “If you’ve been approved into the program, on Friday, we don’t expect to see you at your desk. You’ll be in our lab or you’ll be collaborating with other people,” said Singhal.

The P3 model is codified into employee agreements and the intellectual property developed during this time does not belong to Fusenet, he said.

If an employee spends three months working every Friday to develop a new technology for better video compression, for example, and then presents it to the company, the idea still belongs to the employee, said Singhal.

Fusenet will ask the employee how much they want to sell the idea for or whether they want to start a company that will sell or license the product, he said. “We’ll help you market that and say, ‘We’ll take 50 per cent of the equity, you take the other 50 per cent,’” he said.

“We will help you with money, we will give you all the resources you need – marketing, customer service, R&D – but you get to keep a significant chunk of the equity in the business as opposed to having just the pride of being able to say you started it,” he said.

The policy applies to all employees, but it’s the software developers who are most likely to come up with the ideas, said Singhal. “We thought this was an interesting model … 99 per cent of the companies out there will take the software,” he said.

Fusenet has experienced one major success, one emerging success and two failures as a result of the model, said Singhal. Another five projects are currently in the R&D stage, he said.

Of course there is a caveat noted in the story about how such an arrangement must be carefully documented. I could also see a few risks associated with this as far as delineation of IP and who owns what. Very often, when new ideas spring up, they may be closely related to some existing intellectual property or based upon it. The question then is where the dividing line is or should be drawn and how that is set out in the documents. Not an insurmountable issue but one that does warrant a bit of thought.

I certainly admire Fusenet for having the vision and courage to adopt such a model. Of course, it’s no guarantee for success but certainly puts all the right incentives in place to have an environment conducive to that. I really do hope to see some interesting things come out of their shop in the near future. They will, after all, be very likely to attract the right sort of folks with this program.

standardized seed financing docs

Great article by Brad Feld on attempts to draw up standardized seed round funding documents. According to Brad there have now been four different sets of template documents developed in the US for use in seed round financings, each of which is a little bit different. He is now attempting to reach out to some US law firms in an attempt to come up with one single set for the US. Why? To reduce the inevitable haggling and negotiation over terms and reduce legal fees.

If you’re looking for first round financing, worth taking a look at just to get a sense of what sort of terms have achieved some measure of acceptance as being “market” (or at least that some VCs and entrepreneurs can agree on). That being said, if you’re in Canada, some of the things won’t quite work due to differences in the law.

Seems like a great idea. Anyone aware of an initiative like this in Canada?

vc monster

Saw a very interesting interview with a gentleman by the name of Rob Monster, who heads up Monster Venture Partners in the US. Mr. Monster is a well-heeled entrepreneur who has had considerable success as such. In the story, he outlines his particular investment strategy and the reasons for it:

In an interview this week, Monster said he plans to invest in about three to five companies each year in the healthcare services and online marketing sectors, with investments ranging in size from $250,000 to $1.2 million. That’s a hefty amount for an individual investor, but Monster – who has been investing since he was 12 years old and started working at the American Stock Exchange at 17 – is experimenting with a new approach he dubs “angel (investing) on steroids.”

“There is a middle ground between angel investing and venture investing and that sweet spot is woefully underserved,” said Monster.

As well as his perception of the existing VC market:

MONSTER: “Venture has earned, deservedly, a bad rap for being not forward looking in its approach to creating value in partnership with the entrepreneur. (Venture capitalists) have become short sighted … and tend to design financing structures in a way that biases toward preferences that are not aligned with the objectives of the common shareholders. And they can optimize certain outcomes in favor of the preferred shareholder, none of which, per se, is wrong. But from the standpoint of the entrepreneur they have figured it out…. Entrepreneurs are kind of backlashing a little bit… There is now an accountability for VCs to behave and to follow through on their commitments of being a partner of building a company. But a lot of times VCs get involved and say they have all of these strategic relationships and will make all of these introductions and then it doesn’t happen. This is the universal rant of most entrepreneurs that have interacted with VCs.”

MVP plans to invest through simple common shares, rather than the typical preferred shares with minimum returns and liquidation preferences, anti-dilution rights and so on. His reasons:

“Whatever happened to investing and being right there in the trenches with the fellow company builder, as opposed to baking in a preference whereby I can win and you can lose? My personal view is that the guys who back a company have a responsibility to help the company be successful.”

I recall giving a speech (an admittedly poor one to be perfectly honest) a couple of years ago about how the use of common shares seemed to be increasing as a financing vehicle for not only angel type rounds, but also early stage VC rounds. It didn’t quite ring with some of the VCs that were also presenting, so its interesting to now see a fund specifically and deliberately adopting common shares as its primary investment vehicle.

I’ve had the pleasure of some (very limited) interaction with MVP – quick, straightforward and candid. However, he’s not without his detractors (see for example some of the rather stinging comments in the above article). It will be very interesting to see how things work out.

robert goddard, the fraud

Don’t remember how I ran across this – I think this past week  it was Robert Goddard’s birthday or anniversary since he first invented the rocket. In any event, I ran across the article in the TIME 100 about him. I had no idea that, at the time he published his first paper on rocket technology, most of his colleagues did not believe it to be viable technology. Even worse, the New York Times, in a 1920 article, stated:

As anyone knew, the paper explained with an editorial eye roll, space travel was impossible, since without atmosphere to push against, a rocket could not move so much as an inch. Professor Goddard, it was clear, lacked “the knowledge ladled out daily in high schools.”

Needless to say, they were just a bit, shall we say, off the mark.

To me, the story serves as an interesting reminder to think carefully when you hear about someone’s “crazy” ideas. It reminds me of some of the harsh criticisms I’ve heard doled out by VCs against fledgeling companies. It reminds me of a story I heard about a very, very good lawyer turning down a couple of entrepreneurs as clients as they were kind of scruffy and had ideas that were a bit out there (only to see them sell their company for hundreds of millions just a couple of years later). It reminds me that in Canada, growth of fledgeling companies – real innovators and risk takers – just doesn’t seem to happen at the same level it does down in the US – not nearly the same. It reminds me that very few companies who start in Canada (assuming their founders don’t decide just to move to the US) stay to grow in Canada.

Don’t get me wrong – I’m not saying that there aren’t any silly, stupid and just plain crazy entrepreneurs out there who’s ideas aren’t worth a plug nickel and whose plans are doomed to failure. But even then, it makes me wonder whether here, in Canada, we have perhaps gotten too conservative, too critical and too quick to dismiss things that might, just might, work out very well. I wonder sometimes if Canada has become the New York Times circa 1920.

Top Ten Twenty Lies

Yes, this is a bit old, but quite good. I was wandering around and found these two articles on Guy Kawasaki’s website, about The Top Ten Lies of Venture Capitalists and The Top Ten Lies of Entrepreneurs. Great, great reading. One small snippet from each. On the VC side:

“This is a vanilla term sheet.” There is no such thing as a vanilla term sheet. Do you think corporate finance attorneys are paid $400/hour to push out vanilla term sheets? If entrepreneurs insist on using a flavor of ice cream to describe term sheets, the only flavor that works is Rocky Road. This is why they need their own $400/hour attorney too–as opposed to Uncle Joe the divorce lawyer.

and one on the Entrepreneur side:

“Oracle is too big/dumb/slow to be a threat.” Larry Ellison has his own jet. He can keep the San Jose Airport open for his late night landings. His boat is so big that it can barely get under the Golden Gate Bridge. Meanwhile, entrepreneurs are flying on Southwest out of Oakland and stealing the free peanuts. There’s a reason why Larry is where he is, and entrepreneurs are where they are, and it’s not that he’s big, dumb, and slow. Competing with Oracle, Microsoft, and other large companies is a very difficult task. Entrepreneurs who utter this lie look at best naive. You think it’s bravado, but venture capitalists think it’s stupidity.

Great stuff.