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.

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?

google ventures is up and running

Announcement last night on the Official Google Blog:

Today we’re excited to announce Google Ventures, Google’s new venture capital fund.

At its core, Google Ventures is charged with finding and helping to develop exceptional start-ups. We’ll be focusing on early stage investments across a diverse range of industries, including consumer Internet, software, clean-tech, bio-tech, health care and, no doubt, other areas we haven’t thought of yet.

Perhaps not a surprise, as there were reports (like this one in the WSJ) in mid-2008 that this was in the works. So far, it seems reactions are mixed – not necessarily to Google Ventures per se but to corporate VCs in general. The WSJ had this to say:

Their track records have been mixed. Corporate venture-capital arms have been hampered by challenges that traditional venture-capital businesses don’t face. Venture capitalists invest in private start-ups at an early stage, usually in hopes of a big payout if the company is sold or if its stock goes public.

Many start-ups fear that taking corporate money limits their options and comes with strings that could turn away other potential investors — such as a right to buy the company at a later date. Some funds with less competitive compensation have struggled to retain managers, and corporate venture funds often don’t allow senior employees to invest personal money in their funds, while other venture funds typically do.

This is also echoed by some traditional VCs, including Fred Wilson of Union Square Ventures (who by the way writes a great blog – highly recommended) who concluded in his post:

But I do think that venture investing is not the best use of a corporation’s capital and that it is inevitable that it will produce sub-par returns at best and significant losses at worst.

He cites the same reasons above in the WSJ article and also suggests that corporate VCs will have difficulty retaining talented fund management.

Corporate VCs, like strategic purchasers in M&A deals, may have longer term strategic objectives that, over a longer term, will result in benefits to them. In this regard, corporate VCs can be likened to some extent to strategic purchasers in an M&A context (while traditional VCs can be liked more to financial purchasers). In this regard, one of the advantages of corporate VCs to investees is that they will often have a longer term view of their investment than their traditional VC counterparts – they won’t be under the same constraints to book gains and make their LPs happy or to meet the horizon of their fund. In this case, the very thing that Fred suggests is a weakness of corporate VCs could well be an advantage to an investee company, depending of course on the objectives of the investee.

For the same reason, I’m not sure if it would be valid to say that corporate VCs are or are likelier to (as compared with traditional VCs) fail, because if the focus is on longer term objectives, realized profits as reported on the corporate VC’s income statement might not accurately reflect the actual benefit. At the simplest level, it could allow a company like Google, which has traditionally simply acquired companies that interest it outright, to hedge it’s bets. If the company is wildly successful, and Google wants to buy it outright, it will have saved a few dollars by having put in money at an earlier stage (and presumably much lower valuations). Depending on how things are structured and accounted for, I’m not sure whether the savings in that situation would necessarily be reflected in the measured earnings of the corporate VC. But apart from actual savings, VC investing will also allow Google to gain an insider’s perspective on its investees at an earlier stage and to better assess how things are coming along, and to help them along. This itself may be worthwhile relative to the costs associated with researching potential acquisition targets at a later stage.

I’m not suggesting that in all cases Google will be using Google Ventures as a farm team for potential acquisitions. But even if it isn’t, it may well develop better and deeper relationships with entrepreneurial companies that it could later partner with or enter into some sort of strategic relationship that will enable it to realize financial benefits going beyond those measured in the VC arm’s financials. And it will be better positioned to do so as an investor in the company.

Not to say that life with corporate VCs is all wine and roses. There are often thorny issues to deal with, particularly when it comes to commercial dealings between an investee and an investor, as Fred notes, and things like purchase options (which I’ve seen proposed a few times and for which the answer is a relatively consistent “no” from investees).

All that being said, an article in Wired suggests Google Ventures will act more like a traditional VC:

The fund, to be called Google Ventures, will be wholly owned by Google, but will operate as a separate entity and will seek investment opportunities to maximize returns rather than looking for investments that strictly fit with Google’s strategic vision.

Several high-tech companies have in-house venture capital arms, including Intel and Motorola, But Maris said that Google Ventures will have more in common with traditional venture capital firms.

“We’re making financial return our first lens,” said Maris. But he noted that a part of the appeal of Google Ventures for start-up firms is the relationship to Google and its 20,000 employees.

Interesting. I guess we’ll see. In the meantime, if you’re looking for financing, go to the Google Ventures site.

new startup vc fund

Most of you have probably already seen the story in the Globe. on the new partialy government participating VC fund:

TORONTO — The Ontario government has unveiled a
new $165-million venture capital fund that will provide much-needed
capital to start-up companies in the province.

The fund is a partnership between the government and some of the
province’s largest pension managers and financial institutions. John
Wilkinson, Ontario’s new Minister of Research and Innovation, said in
an interview that this is the first time the province has entered into
a direct partnership with the private sector.

The government is injecting $90-million into the fund and is counting
on the private sector to kick in another $180-million, Mr. Wilkinson
said. So far, Ontario Municipal Employees Retirement System, Royal Bank
of Canada, the Business Development Bank of Canada and Manulife
Financial Corp. have invested a total of $75-million.

Very good news, I think, for entrepreneurs in Ontario. As many readers of this blog know, Canada in general has suffered from chronic underfunding for startups compared to our neighbours to the south, with the result often being that many startups will simply not bother and head south straightaway. Not a good thing, IMHO. <soapbox>Hopefully this will be the first step to showing the world that Canada is a great place to start and run a business, in addition to being a great place to invest. </soapbox>

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.

The Virtues and Evils of Open Source – Part II

Found the article that triggered my previous post – was a piece written by Suzanne Dingwall Williams in her blog. The nub:

If you want to sell your own proprietary software, make sure you have a strictly enforced policy against using open source. Here’s why: even if you agree that open source has crossed the chasm in the lifecycle that is technology adoption, your investors have not. Even the inclusion of an inconsequential open source tool can cause headaches, or stop a deal altogether.

Here are the concerns often raised about open source at the due diligence stage:
– there is no meaningful warranty or indemnity for this portion of the product
– how do we know the open source license is enforceable?
– do the terms for this piece of open source contaminate the rest of your product?
– if this was inadvertently incorporated into the product, what else was?

I should emphasize that I don’t necessarily disagree with the concerns she notes. They are concerns. Particularly in the specific instance she notes – i.e. selling proprietary software (as opposed to using an open source business model). That being said whether or not the benefits will outweigh the risks will depend on many things, including the business model of the startup (even if one chooses to go the route of developing proprietary software), the license governing the open source code and of course how its used. I don’t necessarily think that companies (including startups) should just have a flat policy not to use open source. But I’ve already rambled on about this in my previous post.

But then again, I’m not a VC. And Suzie apparently used to be one. It would be interesting to know what VCs generally think. Are you a VC? If so it would be great if you could go to the poll at the bottom of the left column. Nothing super scientific, admittedly, but I’d be interested in seeing what the general sentiment is.

Venture Capital Valuations

OK I lied – just a few quick posts since its been so long and I need a break from drafting.

For all of you out there looking to value your 2.0 startups go take a look at Bubbleprice. An amazingly sophisticated set of proprietary algorithms developed by industry veterans allows you to input primary and secondary valuation factors used by those in the industry to give a precise indication of economic value. Fascinating, fascinating technology.

An example can be found below:

In fact, I’d be happy to take a half of that. Or a third. Even a tenth.

Of Search Engines and Competition

Interesting post on the Wellington Financial blog. In short, sounds like they think the success of a new vc financed search engine hakia is unlikely to be around very long. An excerpt.

But it really isn’t clear why the rest of us will rip out the Google toolbars or Yahoo Finance pages and convert to another aggregator. Well, maybe we could stand t dump Yahoo Finance.

Youtube, flickr and the like were serving a need. There’s no obvious need for a better search engine. And if there is, Google has proven that they have a few billion to invest on improvements and the currency to acquire along the way.

imho the better question would be why not? changing a search engine is about as hard as changing your undies – either type it in or change your homepage. why even bother with a toolbar? no idea about hakia but i do remember yahoo, altavista, hotbot and a couple of other engines that were at one time or another at the top of the heap.

relatively speaking, in terms of switching costs from the user perspective a search engine isn’t close to most other things (e.g. operating system, office applications, etc.).

and sure, google has lots of coin. but at one point it didn’t. and there wasn’t exactly an absence of search engines when they popped up…

will it be a success? no idea. could it? why not? I’d certainly use it if it’s better than google.

BTW, in case someone from WF is reading this here, tried leaving a comment, couldn’t as your captcha doesn’t seem to be working and PS you might want to try hashcash instead.

Update: and its not like Google hasn’t had its fair share of troubles lately.