Zuck's 3-dimensional chess game

Two billion dollars for Oculus.   I could not believe that Zuckerberg would pay that kind of money for a character from Mad Max 2: The Road Warrior.   Oops, turns out that the character in the movie was called the Humungus, not Oculus.  My bad.   

jmilbery.jpg

By all accounts, Zuckerberg is a very smart guy, much smarter than I am.  He's got to be playing some sort of 3-dimensional chess game with Facebook's future and all we can do is study his tactics and take a guess at his strategy.    Instagram for $715 million.   Not profitable, but they had lots of users and were encroaching on a function that Facebook deemed to be critical for the future of social media —photo sharing.   WhatsApp, nineteen billion dollars.   Again, not turning a profit, but the company had phenomenal user growth and a very strong international presence.   I can't see why it's worth nineteen billion dollars, but adding 450 million users to the FB empire seems like a smart decision. Facebook isn't exactly paying cash for them anyway.

Oculus, two billion dollars. 

Two billion dollars for what seems like a really fancy science project.  This is no tactic; this is strategy. It’s like when Bobby Fischer sacrificed his queen at the Rosenwald Memorial Tournament. It was an expensive move that offered no immediate gain. No one knew why he did it but, considering the player, no one walked out on the game. Only Fischer knew that he was making a play—taking on risk he deemed acceptable—to ultimately assume control of the board. 

Zuckerberg is seeing something that I don't.  Virtual reality is hard to do well and, even though Oculus has some very smart people working on it, I don't see the fit in the short term.   Therefore, Oculus must be a REAL long-term play for Facebook. 

That's the difference between venture investing and private equity investing.

Zuckerberg and company have to place big bets and risk making huge mistakes in order to control the future of big markets.   In the middle market we can't afford to make huge mistakes.   There are no white knights willing to pay billions for science projects in the middle market. Ours is a different game.   We're not playing 3-D chess in the middle market, we’re boxing.  It’s a sweet science that combines nuanced tactical action with straightforward strategy. Our long game requires us to win one round at a time— customer by customer —and I'm plenty tough enough to do that.

The Magical Kingdom of Venture Superlatives

Attacking the Big Boys

There was a great piece on Foursquare in yesterday's VentureBeat that I thought might be worth a quick word.   Not because I am particularly interested in FourSquare, (tried it a year or so ago and didn't find it all that appealing/useful/enjoyable).  It's interesting to me because the article is a great example of the use of uber-superlatives that are the bread and butter of venture-backed technology companies.    Let's start with the title of the article.   Foursquare's CEO (by all accounts a smart dude) was speaking at the Structured Data conference and he commented that Google and Yelp are "...incredibly broken...".   Now I'm no expert, but I've used both Google and Yelp in the context of mobile search and they didn't seem all that horrible to me.  The good news is that Foursquare offers a competing solution that is MAGICAL.    That's right, MAGICAL.  It's all black and white in the venture business.   Competitors are INCREDIBLY BROKEN and you are MAGICAL.

It's downright MAGICAL!

Since venture-backed companies are always swinging for the fences, it's vitally important that they make themselves the solution for a HUGE problem that isn't solved by the entrenched vendors (whether this is actually true or not).   You either need to capture a massive number of customers and become profitable, (Google, FaceBook, etc.) or you need to get big enough to scare the bejesus out of one of the big boys so that they buy you (WhatsApp, Instagram, etc.).   That's basically it.   You can't be a great solution for a small set of the market or a really good point solution for a niche market.  You have be solving a HUGE problem for a HUGE market that the BIGBOYS are failing to solve in a truly HORRIBLE WAY.    Thus, Foursquare is not just a better solution for mobile search, Google and Yelp are INCREDIBLY BROKEN.  

On the middle-market private equity side, we have investments in very profitable companies that serve smaller markets (i.e. thousands of customers) with really good products.   You can make great money without ever having to hope that you get swallowed up by a larger company -- because you aren't worried about running out of money.    A large percentage of venture-backed companies fail (40% by some counts).   I find that so hard to believe when their competitors are so HORRIBLY BROKEN and all of these fledgling startups are so MAGICAL.

-- Jim Milbery

WhatsApp Doc?

Jim's take on it.

Jim's take on it.

By now, everybody in the galaxy is aware that Facebook is paying some $19 billion in cash and stock for chat application vendor WhatsApp.   Congratulations, Sequoia.  Great exit for a great group of venture guys.  Congratulations to the WhatsApp team as well, $355 million per employee is a terrific outcome.  There will be a metric TON of folks opining on this deal from the win/loss perspective, so there is no need for me to belabor the point here.  I'd pay particular attention to anything that Mark Shuster writes on this topic, or anything that Dave Kellogg writes.    From the middle market, I look at this as a cautionary tale for several reasons.

For Founders -- it matters who owns you and who buys you.

There is no doubt that Sequioa was going to take this deal, $19 BILLION for a company that was MAYBE generating $350 million in revenues (best case) and no profits.   Did the founders want to sell?   Probably.  However, they famously eschewed advertising dollars, public marketing efforts and anything else that made them look like everybody else in the social media space.   They gave their users a free year of usage for WhatsApp and then charged $1/year after that.  Seems like they were very strong in the international market where SMS charges were expensive and WiFi access was cheap - so $1/year is a GREAT price.  But they weren't making any profits at a $1/year.   They sold the company to Facebook and you can bet your "likes" that Zuckerberg has plans for WhatsApp well beyond charging a dollar per year to those customers.  Zuck gave the WhatsApp founders a seat on Facebook's board as part of the deal.  That way they'll get a front row seat for the show.   The WhatsApp software has access to ALL OF YOUR CONTACTS.  The ultimate social graph.   Let the monetizing begin.  As founders they may no longer care what happens at a price of $19 Billion.  If they do care, well, the emperor knows that the rebel fleet ain't on Dantoine.  

For Middle Market Customers

WhatsApp isn't really a business-to-business software application - although it could be used that way.   The parallel here is that as a customer you need to be really careful about which applications you build your business around, especially venture-backed businesses.   Once the venture guys sell the company to a Google or a Facebook or an Oracle, things are going to change.   And they are going to change for the better of the new owners, not the customers.   So make sure that you have a backup strategy in place, because you may not be hapy with the new boss.  In real life it's not like the Who promised that it would be -- the new boss AIN'T ALWAYS LIKE THE OLD BOSS.


My reaction to this news is obviously "great for the team, great for the investors, great for Facebook because they really believe this is a game-changer for them."  Haters gonna hate but you won't hear any knocks from me on the team for giving up too soon or the VCs for pushing the exit.  What fascinates me about this story is how they got to this big announcement in the first place.

Devin's take on it

Devin's take on it

First, it starts with product.  WhatsApp's founders had a vision, they even taped it to their desks.  They were maniacally focused on product from the start -- it had to work, it had to be clean and it had to be fast.  That's it.  No flourishes, no extras.  Just a great solution that delighted its users.  Which it clearly does.

Second, it had to scale.  They built a product with 450 million customers with only 50 employees.  Sure, maybe that's simpler in the mobile app market versus the enterprise software market, but still . . . well done.

Third, they had to get in someone's way.  Strategic buyers don't go around buying companies anymore.  They buy products that either 1) cause them pain or 2) give them a return on investment.  WhatsApp wasn't causing FB a whole lot of pain yet, but Zuck is thinking 10, 20 years out.  And he has the control to do what he wants.  Control has always been on the top of his list even as a venture-backed CEO and now as a public company.

Fourth, have more than one interested buyer.  It's tough to run a successful auction when there is only one person in the room.  You can only get top dollar when you have competition and rumors are that Google was interested at about $10 billion.  A good banker can help get you that last bit of value and it looks like Morgan Stanley did their job for WhatsApp's team and investors.  But if you don't have the first three on this list, even the best banker can't magically create interest when there isn't any.

When it comes to programming languages, avoid the long tail

A brief diatribe on "long tails" in programming languages.

RubyMine IDE

RubyMine IDE

I was thinking about programming languages the other day, specifically about choosing one particular language over another.  And, whether I care which language any of our companies plan to use for a given project.   The bottom line is I don’t really care as different situations likely warrant different choices.  But I am cautious about two things.  First, I am careful about steering clear of languages that are getting a little too long in the tooth.   Second, I don't want to be too far out in front of the language.  The only thing worse than coding in a formerly-was-popular-language is maintaining code that was written in a never-was-popular-language. 

Let's talk about old code first. 

Take COBOL for example.  Yes, there have been tons of great upgrades and advances in the COBOL language in recent years. (Thank YOU, Grace Hopper).  But it's an OLD language, born in 1959. And sure, the folks at Micro Focus offer a pretty advanced, visual version of COBOL with tons of bells and whistles.  Heck, I would hazard to guess that you could probably build some fairly interesting things with their COBOL platform (maybe even RESTful interfaces for your web applications).  To be fair I actually don’t know, but I am assuming they have kept the language pretty current.  So why I would not want our companies developing in COBOL?  I think it’s pretty hard to get your hands on good COBOL developers.  I don’t see lot of kids coming out of college wanting to learn COBOL.  Nobody is banging a drum to say that COBOL is something that they want to learn.  So whether COBOL is effective or not effective for building a particular application does not really matter at this point. I would argue that writing a COBOL program and the logic layer for some RESTful web services interface would probably work just fine.  It’s a fairly powerful language but the problem is finding people that know how to do it and want to do it.  Clearly this is an extreme example.  You are unlikely to choose COBOL as a language unless your company has a huge ongoing inventory of COBOL programs to manage already.

For my part, I have written a lot of CFML (Cold Fusion) over the years.  Not good code mind you, but code nonetheless. My friend and compatriot Alan Willamson cringes when he hears me say "programming in Cold Fusion", because I write a lot of crap.  Mostly throw away stuff, proof of concept stuff, the kind of code that shouldn’t be checked into SVN.   There continues to be ongoing investment in the CFML language, and not just from Adobe, but from a number of open source teams.  In fact, Alan and the rest of the BlueDragon guys have done a great job of providing an open source platform for CFML.  It's fast, it's free, and there is a ton of functionality built into the platform.  Still, I don't see too many newbie developers hankering to learn CFML.  For me, it's a go-to language for getting something done quickly.  BlueDragon is written in Java, and I can write Java code directly in a script block in CFML.  So it’s definitely the language I tend drop into when I have to do something incredibly quick.  (Ok, ok, I sometimes us Transact-SQL for similar, albeit uglier, purposes if there is data involved).  

 Powerbuilder, it's like your dad's rock music, only much, much worse

Most people aren’t going to want to program in CFML anymore and it has nothing to do with the capabilities of the language.  In the right developer's hands, you can use CFML for a data access layer and restful web service business logic layer and you can do some dynamite things with it.  It’s got enough object oriented capabilties to allow you to write code in a modern way.  (We can get into a whole other academic argument about this last point, but let's not and just say that we did).   So while CFML is still a powerful language, I'd really worry about how easy it is going to be to find developers that want to write CFML.  (And yet, we have a number of large scale CFML projects in our portfolio).   There are a whole bunch of dead languages that once had a massive following that I'd throw into this same category.  (CFML isn't there yet, but it is probably headed there).  Anybody remember PowerBuilder? It was clearly the dominant programming language of the go-go client/server days, maybe not as dominant as COBOL once was in the 70s and 80s, but close.  You can still buy PowerBuilder, it’s even got enhancements to handle server-side development. The thing is, who wants to program in PowerBuilder anymore?  When I am in a meeting with 25 year olds, most of them haven't ever even heard of PowerBuilder.   Much like kids don't want to listen to their parent's music, most developers don't wany to program in their parent's programming language.  Younger developers want something new.  Whether it’s better or not it doesn’t matter.  You can make favorable arguments in favor of a bunch of different "old" languages as far as feature/function is considered.   But as Bill Murray once yelled out in "Meatballs", It Just Doesn't Matter.  New developers are going to choose C# over VB.Net (even though both languages get access to the same set of features via Microsoft's CLR).  That battle is over.  To be fair, Visual Basic and the grandaddy of them all, "C", stil rank fairly high in Tiobe's programming language popularity chart. In the case of "C", I'd argue that system software still tends to be written in "C", so it will always have a following.   In VB's case, I'd argue that it's the long tail of legacy applications. Since software applications can have a fairly long life, programming languages tend to have a very long tail.  Nobody's really writing new stuff in them anymore, but there is still a ton of old software that needs to be maintained.  

New kids on the block

On the other end of the scale are new languages that might or might not catch on, such as Google Dart.   (Again, dear reader, I am not arguing either for or against Dart, just making the point that it is a relatively new language/platform and therefore does not have a large following of well-trained developers as compared to Java or PHP or Ruby as of this writing).   New developers don't really want to program in old languages, and I don't really want new developers building applications on a language that might not live very long.   There is nothing worse than having to maintain lousy code written in a language that never really caught on.   Dart could end up being the next PowerBuilder, or the next Ruby.  (But it might be the next Ada).   The problem with new languages for mid-market companies is cost.  The laws of supply and demand dictate that when you have a short supply of something (i.e programmers that know DART) then it's going to be really expensive to pay those people.   And you're going to get outbid by the larger corporations and the venture-backed companies in Boston, Austin and San Francisco for DART talent.


The other problem with the leading edge is that you still have lots bugs (or missing features) in these products.  You are still "debugging" the language to some degree. They can't do certain things (like maybe connect to your favorite database).   So you end up waiting around for the "complete solution" as Geoffrey Moore would put it.   Furthermore, most new languages lack a set of well-understood "best practices" early on in their lifecycle.  The code that you write might end up needing to be rewritten to achieve scalability or reliability.  The bottom line is that I don't want to skew too far back or too far forward when it comes to programming languages.  You don’t get the benefits out of being out on the edges -- at least in the middle market. Beyond that, I don't really care.

In the end, you have to make a choice

 I tend to skew toward open source languages these days (or really low cost languages at the very least).  PHP, Ruby, Python, Java and JavaScript are all good choices.  (Let's leave frameworks and libraries for another discussion -- that's right, I'm talking to you Node.js).  All of these platforms are relatively hot, so kids coming out of school know them, people are interested in coding in these languages and yet there is mindshare around them so that you can build a decent platform doing it.  What about proprietary languages, C# or Objective-C?  Well, if you are already a heavy Microsoft shop and plan to stay that way, then I'd say have at it with C#.   With Objective-C it's a little more complex, because you are unlikely to write server-side code on the Apple platform.  If you want to write iOS applications, then you are going to have to write in Objective-C, but you will also be writing code in at least one other language.    

Personally, if  I had to start something new today for a "greenfield",  would I code to the Microsoft platform?   Probably not.  

In summary,  I am sure I am going to be flamed all over the place by everybody with an axe to grind for disrespecting their favorite language.  Remember, I am not arguing the point that one language is better than another, or that one platform is superior to another.  And let's leave a more detailed discussion of task-specific-solutions, such as "R", for another day.   If it can do the job and you can easily find people to write the code, well, then that's good enough for me.

But if the only folks that can program in it still remember 300 baud modems, or only five geniuses in the world are familiar with it, then I'd politely suggest that you might want to consider something else.

If I was going to start building something new?  Java and C# are fine choices.  Ruby seems to be going up and down in popularity, but I'm having lots of fun tinkering with Ruby.  My one bias against Ruby is that our hometown of Chicago is the hub of the Ruby-on-Rails mafia -- where Ruby is the solution to any problem.    Python seems to be on everybody’s short list.  Google's a big Python shop, and all of the things you can do with the Google App Engine integrate easily with Python.   Generally speaking, open source tends to be a better choice if you have got a green field because all of your cloud-based platforms are supporting any number of open-source programming stacks.  

Just try not to be too far out on the edges.

-- Jim Milbery

David Sinyard Interview Transcript [edited]

David Sinyard's "Heuristics in PE Decision Making"

Devin: This is the interview portion of the podcast today with me I have David Sinyard, who wrote a fascinating paper that we have talked about before and we have referenced on the blog at www.pefuncast.com.  The official title his paper is "The investment process used by private equity firms: does the Affect heuristic impact decision making?" That’s the official academic version of it.  Maybe the colloquial version of it is: you said what? Huh? What do you mean by that?  So David why don’t you tell our listener, the one confirmed listener we have, what you do in your day job and how you got onto this topic and then we will go from there.  Thanks.

David: My name is David Sinyard and we have a mid-market investment bank located in Atlanta.  I have been in the deal business all my career which is about 30 years.  I started coming out of my MBA in commercial real estate and did it worldwide, some PE sponsored, after then I ended up in the deal business.  Later in life I decided to go back to school and pursue a doctorate and this paper came out as a result of my doctoral dissertation which was an interesting exercise by itself.  This was a big decision I made.  I got to the topic by doing some research and found a lot of businesses went through the transition in the next few years, you know with the baby boomers age and it would seem that private equity would be a natural investor.  I did some work, ran into a professor in the University of Montreal who had done something in this area whose name is Alexandra Dawson, and she mentioned a lot of the research was being done into bias and decision making which basically from an academic view is how do people use shortcuts to make decisions and what bias does that lead to?  So with her help and direction I ended up starting the paper, looked at some of the statistics and the PriceWaterhouseCoopers data shows that owners are not sure that 50% of the children can run these businesses.  25% are going to give their children their stockholdings and keep professional management and 17% are going to sell the business.  So it leads to the idea of how do you focus on preparing and showing a business to PE from the perspective of an entrepreneur who started it.  She feels the family isn’t interested, can’t do it so that leads to whole conversation of these heuristics.  A heuristic basically is a shortcut that people use, cognitive heuristics are shortcuts people use in terms of making decision.

Devin: And a lot of research you know obviously the book Thinking Fast and Slow right, New York Times bestseller about the topic I think that probably 1/100th of the people that that bought the book actually read, because it’s pretty big slog to get through but certainly popularized these things as popular economics which is starting to maybe trump traditional economics.  So you know obviously you are the thinking man’s investment banker, getting a PhD in thinking about these thoughts.  That’s pretty unique not to knock investment bankers but trying to get to the source of the decision making and what drives founders right? That’s a whole other topic, what drives founders to run companies to raise capital or not raise capital, but then how do decisions get made on the investment side of things.  A lot written on venture capitalist is raised but not a lot written about private equity at all.  As you dug into this what did you find? And I think you are carving some new ground here.

David: Right well you are right, the research most of it today has been in venture capital [inaudible] has really taken the lead in that.  They have done work in the- it will be interesting to you as it would be to me.  So in private equity say you know our decision making is this.  These are the things we are looking for when in fact the deals the do are something different.  Let me talk to an entrepreneur in a bank who are trying to position themselves because what you really want to do I know what the decision is and what they say it is for.   Their biases that you often see is the over confidence everybody knows you get confirmation bias and so you are going to look for a deal that confirms your belief in the deal.  You know some people may be too cautious and then there is the great thing from the corporate environment I spent a few years there, the whole group thinking you build consensus and challenge the view and challenge the decisions.  Those people become aware of these.  If you are playing a PEG, from the PEG perspective is how can you make a process adjust so you make better decisions and there is some recent research out there to try to moderate or minimize the impact of the decision making bias so it actually increase a lot of the investors for the PEG.  From my side, for my clients what I want to be able to do is understand how to present and you know put the deal on the best light to the PEG, have the founders, or my clients and entrepreneurs understand how the PEG is going to look at their business.  What are their strengths and weaknesses so we can position it best so we can have a successful outcome?  Which, from my side is representing our client, and get the best valuation and best structure we can get.

Devin: And when you say PEG, you mean Private Equity Group right? That’s your shorthand for Private Equity Group?

David: Yeah.

Devin: I read a long time ago, an ex-partner from Highland Capital, a big venture capital fund in Boston, who went on to teach at Harvard Business School in the entrepreneurship programm, he wrote a case study about private equity and venture capital, how to manage a venture capital firm and how they generally get managed.  And he said in the best cases, instances of partnership can’t stop you or can’t force you to make good decisions.  That is not going to guarantee that every decision maker is great. A partnership at its best stops you from making bad decisions and that’s stuck with me for you know 15 years  when a partnership that, and I think we will get into this about how partnerships and private equity firms are structured and how decisions gets made sometimes, every decision made isn’t going to be great but if you are open and honest and put things on the table you can stop that consensus building and stop yourself from making a decision you shouldn’t make, which is sometimes a money saving decision if you don’t make a decision.  So was that really the spark for you on this was I have worked with these founders and I have worked with these private equity firms and other investors, you know I am curious about peeling back these things, is that what the spark was or was it something else?

David: It was basically quite heavily in the academic environment, but what academics are interested in is something that is new, something that adds to existing theoretical work and has an opening to put it.  So there is what’s interesting in this whole heuristic arena is that it’s popular in in the Harvard Business Review and Mckenizie.  It’s a theme that has been looked at.  A pretty major detail from the practitioner side and the academic side.  So I come out of the practitioner side, put myself in an academic environment.  It’s a natural fit as you will that you can look at these things and for better or for worse I have an understanding of it having done it for as many years as I have and I understand private equity people have access to them so it kind of makes for an interesting topic.

Devin: Everybody has their cross to bear if you have to be friends with private equity guys.

David: Yeah true

Devin: Everybody has got their challenges.  So what were the assumptions having been a practitioner for so long and having these relationships and access and conversation over a professional career.  What were your assumptions going in?

David: Where this got started was I had a conversation with a group on the West Coast.  They were investing in a family business and you know [inaudible].  So it was clear to me that there was something in it and there was, there’s a lot of research on family business and family succession and there is a fair bit on decision making and entrepreneurship.  There is precious little in the private equity world as it relates to decision making as well as family business.  So that really sparked it and then you end up to look something from the academic year.  This was of interest because it really, the psychology of a decision and help people approach them, it’s how you get things done.  You go to the finance department in Georgia state university, they are all econometric modellers which is great but they don’t do much, they do somewhat but not very much work in behavioral finance and ultimately, my experience says that to get deals done, it’s all about the people, the decision making process, how do you solve the problem, how do you present things? And that made it very interesting.

Devin: And the difference in private equity versus venture where that has been all this stuff written about it- we talk about family owned business, the status is you’re buying control for a family owned business.  The family or the patriarch or the matriarch who is running it, owns it, who founded it or maybe the next generation who took it over from their family, isn’t going to own it anymore, isn’t necessarily going to make the decisions in running it.  These are very different dynamics than raising a few million dollars than having VC on your board helping you make decisions and helping you make introductions into your business.  It’s really you are handing control over so it’s a unique dynamic.

David: Right and the structure as you find out, venture capital is going to put in ‘x’ dollars, get a board, going to largely manage to run the business.  Private equity is going to take control, you are going to want the family to roll equity and you are going to want them to remain involved.  It’s a whole different control view form the family.  You are going to have an entrepreneur, maybe second or third generation but it doesn’t matter.  It’s their baby it’s their business, it’s their name and how the cultural mix going forward is pretty important so there is a lot of nuances here that warrant a conversation.  We see it all the time.

Devin: So we will do a second interview someday about the family owned business dynamic and kind of how those businesses are run, what are some common themes in those businesses?  So let’s put that aside for now, let’s get into the meat of your paper around how private equity firms make decisions.  So from your side of the table, how do you view private equity firm is structured and generally kind of what the decision making process when they are evaluating the transaction? Then we will get into these shortcuts and heuristics that come in to play.

David: My experience has been that the private equity group had the general partner managing director, the principles that have the money along with the limited power, and there is sometimes they have the- the problem is how to you get to the gatekeepers to get to the decision makers.  So many have been in the offices and priding themselves.  We were put together a teaser, present it to our contractor who we believe is the gatekeeper of the business development offices I mentioned, and try to get his interest.  One of the things the paper showed, the research showed rather is that these guys see many thousands of deals year.  So here the maths is pretty straight forward.  Looking at 3 or 4 deals a day, what is it they are looking for because they are going to make a decision based on one or two pages of whether they are going to proceed or not.  You have got a very narrow window, how do you get their attention?  That’s the premise from which I started.

Devin: And more often than not the person getting that teaser is not one of the founding or general managers of the firm who is ultimately making the decision.  So they are basing it off of their experience up to that time, their interpretation of what the investment rules or criteria are of the business, and if it’s like healthcare and you don’t invest in healthcare that easy right? But if its healthcare in this sub-sector, you may or may not know the intricacies or nuances in the sector or a certain type of business model that one of your bosses or you know somebody who has been in the business longer would have.  So you are a kind of a conduit for you know it’s like your heuristics on top of heuristics but we will get into that a little bit later.  So you got to get to the gatekeeper right? Then you get to the gatekeeper and in your view what happens? So in something that would transact right? What’s your view?

David: What happens is you get through that stage and the next stage is you get to rely on, you ask some detailed questions, you put out your memorandum.  You get to that stage then you put out another [inaudible] in terms of understanding very general, non-binding, but it’s acceptable to your client and the due diligence begins.  You have management meetings, you put together all the detailed information that an investor would want.  If it’s still a green light then you get the documentation and you eventually close.  That process could take 6-12 month realistically.

Devin: In my view and probably yours as well, is it each one of those steps along the way are critical decision processes right?

David: Right.

Devin: The first time somebody sees that teaser right that one to five page description of the business you know an opportunity could live or die at this point.  You go up and he or she brings it to a partner or somebody who would lead the transaction and at that point they would decide wrong sector right business model or whatever.  Then you get through that, so say you get to a yes then it’s hey I am going to present this to the rest of our team on Monday morning.  Then somebody in that room may say oh I did one of those ten years ago I hate that industry or I hate that business model or we would never do one of those, I lost money in those, or hey a friend of mine runs one of those you should talk to him.  Maybe everybody says I love it and you get into the peeling back the onion on the diligence process which we have talked about a lot on the blog and on the podcast, and each one of those there are different things as you find out more.  You then decide or not decide or decide not to decide let, and then all the way before the cheque gets written, there is, every Monday morning these teams are talking about whether this investment lives or dies and goes on to the next phase.  So at each one of those steps there is decision makings and as you get closer and closer, the risk level amps up for you as the agent for the transaction and the owner of the business who is trying to sell the business right, because you are getting closer to a transition, lots of money exchanging hands, you are getting further away from the other people you were speaking to at the beginning of the process who may also have been interested.  It’s harder to go back to them so the risk amps up for everybody the closer you get to it.  Some things you never discussed at the beginning start getting discussed at the end.  So you have got all this very tense rapidly moving and often shifting landscape that you are trying to manage for your client.

David: Correct.

Devin: Let’s go deeper on heuristics, each of these decision points is heuristics or short cuts come into play.  So you spend a lot of time on the Affect heuristic, there is obviously handfuls more of those in various ways.  So explain what the Affect heuristic is and how it comes into play in this context.

David: In its simplest form of that getting into the academic decision is the Affect heuristic is you basically have a positive or a negative feeling about some stimulus.  So you are going to receive some information and you are going to automatically have a positive or a negative reaction to it.  So you know so I showed the specific research that I did is I showed a number of teasers and wanted to seek reaction about whether people were going to proceed and true enough what [inaudible] whether it’s going to be positive or negative there are a couple of passwords were very telling to me.  One is the whole process of the decision making you have mentioned the money Monday morning meeting, I was really pretty surprised at what I call the continuum of the decision making.  There is one group that had a, you know literally a checklist of 25 criteria and if you made it, scored 65, then they would proceed.  Most of them, and I was surprised by that and I would have loved to have gotten that sheet obviously because it’s very insightful for me and for them it’s part of their process and they are not going to share that, but the more informal decision making part was the really kind of telling thing.  You know they have been doing this for years so they know what each other wants.  That’s pretty nebular and that to me seems that it be open to some risk on the private equity side saying maybe we are missing deals because we really don’t know what everybody wants or you know this overall general agreement that you can quite.  We are looking for 30% returns, well that’s a nice idea but realistically is it the correct investment. So it’s these ideas of wanting up and there is not fixed flag.  We are going to continue to your point you know further along, everybody is not going to get into this, you have six months where the entrepreneur or private equity group has committed resources and money and is still waiting to make sure that everything keeps lining up.  It’s a little disconcerting for everybody I puts a little pressure.

Devin: You were surprised when somebody decided hey we are interested, here isn’t a broader- we are interested we have everybody on board, we will tell you what we need to get done and if everything checks out we are good.  You are surprised, if I am hearing you right, basically the sands can shift any time along the way and it was like we are committed but we are soft committed and we are willing to change out mind at any time.

David: That’s true.  I have been a lender, so in a lending environment its clearer you know if they have the check list and you make a decision and go and this in the private equity world is much more amorphous it’s longer here.  Understandably it’s just surprising to me.  I would, I came in sort of thinking well you are going to have a Monday morning meeting and there is going to be x criteria and if we fit within that we are going to progress and that you are not going to, from the private equity side, waste a lot of time in deals you are not going to make, and this whole funneling of the deal flow is really pretty flow.  You end up closing two so you know there is a lot of fall out along the way and it’s that process that is then interesting to me.
Devin: And there may be two or three investments fighting for oxygen every Monday, so you may not know there are two other investments being considered the same time.  So not only are they evaluating the investment on its own merits, but they are also evaluating it in relative to the other two opportunities they made.  You just may be the second best and they move on from it.

David: I’m sorry you are not going to hear you are second best.

Devin: Yeah you have no idea, it’s just hey we changed our mind or the market size is too small.  Well you knew the market size when we spoke to you 6months ago.

David: Exactly.

Devin: Well some of it is also option value right? I mean people in our business certainly venture capital is rampant with this, it’s like I’m not going to say no because I might change my mind or the business might catch fire and I kind of want to keep my options open.  So I know you see a lot of that which is painful at times.  At least I have tried in my career to help people say am I fast? Yes.  Am I committed yes? Am I fast, no.  Am I perfect fit for you? No.  Even before I send you the teaser.  Tell me what it’s like and if it’s a good fit I will tell you yes.  Once I say yeah I am interested, hopefully I have lined up the ducks internally to say yeah we are really interested in this and we are going to spend time on it.  And that is customer service in our business to people like you because if you have a bunch of deals you walk away from at the 11th hour, you are never going to show me anything again.  It’s going to be a check minus next to my name.  So this Affect heuristic is a relative goodness or badness of something and it’s you know I have talked a little but about system one and system two thinking if you are familiar with Kahneman, what is automatic and what is considered deliberate thought.  System one: automatic, emotional- basically comes from you know your brain stem right.  It is like hard wired in you- fight, flight or freeze.  That is system one.  System two is like okay let me work through this very difficult personal problem and think through all the pros and cons blah blah blah.  Affect heuristic- system one, system two?

David: System one.  I don’t like to use the word emotive because it’s not necessarily emotion, but it’s the good or bad feeling about the stimulus.  So it’s an automatic reaction to the stimulus and therefore its system one.

Devin: Alright so let me try some examples on you. Husband and wife team you know the reaction? Oh we never do that or I did that once and I got killed.  I mean what’s in the evaluative process? You know what are some of the, you know, you have got some great quotes in the paper, and we will put a link up in the website to the paper for sure because it’s really fascinating as you get into some of these quotes.

Devin:  Give me some of these that would be kind of Affect heuristic responses.

David: I ran into this problem 10 or 15 years back and I will quote- you know we are talking over the last ten or twelve common criteria but there is also those kind of negative criteria and the partners had a particular tune if they had gotten burned before.  So a founding partner that slack in a mining deal you are not going to find him in a mining deal.  We have had some automotive experiences that didn’t go well, I think any automotive would have a hard time.  So it’s that automatic we are not going to teach it though.

Devin: So this is, see if it’s 15 years later, the macro and micro trends within the mining and automotive industry have changed dramatically.  You have got somebody in your shop who is bight and done evaluation of this transaction opportunity, is positively inclined to pursue it, may hear in a Monday morning meeting, I got killed in automatic aftermarket 15 years ago and then guess, I mean in my experience that deal is DOA.

David: Oh absolutely.

Devin: There is no coming back from that.

David: So it may be a completely reasonable view for the individual that says that because of his experience. You could argue that as commodity process have improved or in the natural gas fracking, maybe because of the very experience of it they didn’t get in to that.  So you may have walked out of a major opportunity for some investments because of this automatic reaction where there is the risk of that.

Devin: And the risk to you and the risk to your client in your agent role is if that person had spent the last 90 days working on the transaction before they got that feedback, so how quickly do you get that feedback where you realize I can’t fight this tide internally.  One of my partners had a really bad experience in this base and he will never vote yes for this transaction.  Find out on day one that’s great, but find out day ninety one, would be catastrophic to a process you may be trying to manage.

David: Yeah from my view the relationship with the principle entrepreneur, you know if this drags out come back with this later on I look a little silly.  I did it a long time ago on an office building in Richmond and it was a [inaudible] went to the travels board I think Hancock had forgotten. We got turned down, we got turned down because one of these people on that decision making investment committee didn’t like the location of the building or something.  So we got turned down but one of the other guys from the committee came to me well he is retiring in three weeks, just send it back up in a couple of months and we did and we got the deal done.  I mean it’s bizarre if you think about it.

Devin: Oh no I could tell you lots of stories over a career of people with just they say hi I drove, this guy probably said I drove by that corner every day and it’s a dump right? He is not an expert in this specific transition.

David: Blocked the deal yeah.

Devin: Your view of this is that people understand that they are making these broad stroke comments, that they are aware of these shortcuts they are taking, or are they not aware of them?

David: I don’t think they are aware of them.  I think that they are so entrenched and they so believe their own decision they don’t perceive that there is any risk of any bad [inaudible] they just that’s just where they come from.

Devin: Is the impact of that missing good opportunities or bad decision making? I want to get into kind of okay this exists, how do you change it?

David: It’s kind of both you know.  It can be- I think it’s more missing good opportunities in the specific of what we are talking about.  There is risk too in the process.  The whole valuation process is it is set up so you are making the best decision that you can? Ultimately that’s what all these investment strategic decision are.  So back to whole academic stream there is some current thoughts about how to improve the process if you look at some stuff which showed up in the Harvard Business Review a couple of years ago, how you can improve the process.  So you take into account the Affect heuristic, you take into account the biases of everybody in the process so that you try to improve the process through some analysis and I believe that the process is improved, your returns are improved, and statistically they- McKenzie and the guys from the Harvard Business Review article suggested it does.

Devin: Like 530 basis points I think is your math in the paper.

David: Yeah that’s what McKenzie says, yeah.

Devin: So what should happen with that is that this the person who got killed in the mining industry 15 years ago, should he say hey I got killed in the mining industry 15 years ago because I think these were the reason why. We timed the market wrong, we backed the wrong team or we backed the wrong asset you know event risk right? Regulatory environment changed and we got killed.  Let me put that on the table.  I need you to come back with me that those three reasons that we got killed 15 years ago don’t exist today in this current situation and if you can get comfortable with that I am open to suggestions.  Is that what should happen?

David: Yes.

Devin: And does that happen?

David: No.  You know anecdotally I would say no but you know, I would probably imagine that because in the average private equity group you got the decision makers along with the partners, and you know it’s a problem to get people changed to get people to be that reflective.  I was going to say if you are distraught, if you are me representing the entrepreneur, why would I go try to battle that? I am going to go try to find somebody else who understand it.  It’s going to be a little bit easier to do, it’s going to be more open to my arguments.  Now I may be leaving a better valuation, I may be leaving a better culture, I may be leaving lots of things behind, but my perception would be I am not going to be able to change City Hall so I am better off going somewhere else.

Devin: I think you know that’s back to the point we made earlier is you know your risk is not getting an answer fast enough, burning a bunch of calories where you didn’t know there was some partner about to retire in three weeks who is going to kill this deal in committee because he drove by this corner and thought it was a dump.

David: Right, we were 4 months into that.  You can usually envisage the private equity guy correctly going out to partners that he has that have in the street experience, or have geographic experience or whatever and you could be well down the road and you finally get the feedback from the guy playing golf on the Saturday afternoon, saying I got nailed on those deals and you don’t want to do that and it comes back that way.  Those are the things that are difficult for me to handle.  I would rather know up front you know.

Devin: I would like to say that golf buddies have never killed the deal over my career in kind of 20 years of sitting in Monday morning meetings, but unfortunately that does happen from time to time.  It does happen from time to time.  So is there any sense of the size of private equity group where this is more prevalent, less prevalent, did you get an sense as you talked, and did the interviews for the paper you wrote, that this is more prevalent in certain situation or not?

David: No to be candid that would be something I would like to go on task.  We focused on lower mid-market so there is private equity guys that I spoke to are in that arena.  It would be interesting to go and talk to some of the larger groups and possibly some of the international groups and have the same conversations with these and see if they play themselves up the same way.  There, the decision making cognitive you know using the shortcut to there, are they the same and do they play up the same way? I don’t know.  I would imagine to a degree they are but I didn’t get to that.

Devin: So in the private equity guy, that’s my PEG definition, it would be this: hey we look at $1,000 a year David, a 1,000 deals a year David and I got to get to the best ones as fast as possible because it’s competitive out there.  There’s 1,000 funds, you know too many funds chasing too many, too few good deals.  So I got to just cut to the chase, I don’t want my guys going down wormholes that I went down early in my career only to lose money.  So you know what we don’t do mining deals, we are not doing automotive, we are not going to do with the husband or wife team.  That just gets me down from 1,000 to maybe 600, just by saying no to those.  Then we will spend time on the 600 instead of 1,000 and I got to do that because it’s you know tough out there and we got to put money to work and we got to go out and raise the next fund.  So that would be like I got to have these simple rules because we got to focus the machine.

David: Right, that’s fair enough.

Devin: Your argument would be that doesn’t defend for making good decision, you guys have decided.

David: That’s a business decision about how to cull your deals and go down the funnels.  That isn’t the decision of the merits of the investments per se.

Devin: No that’s a very good point, that’s a very good point.  So give me a couple of stories from this process, because I like storytelling and give me some- as you dug into this and reached out to people and asked them to participate and they had some conversations, you know I am not asking to name any names and you certainly don’t in the paper, but you get some really good quotes out of the people you spoke to, but you know if you think of a couple here, just walk me through and I will listen.

David: Well what the paper became was a more insight into a number of heuristics that are used you know how PEGs deliberate.  We have spoken about that from a check list of 25 to we just kind of know what we want.  The, well what’s interesting to me on another level was there is a view that the PEG’s didn’t want invest in deals that have already had PEG investors.  That was pretty, the majority of the people I spoke to and they would offer up well we want to be the first institution of money, what it really came to when we get some of it off the cuff comments was that there is a perception they are going to get a better deal, and the that’s relevant to me representing an entrepreneur saying look you don’t have institutional capital, so they think they are going to get a better buy because you are not as sophisticated and you don’t have the policies and procedures in place.  So that came out of one specific interview, I thought that was pretty telling.  The second thing that came through that was very interesting again to me from my position on this side of the desk, was you often hear that management is what makes or breaks the deal and/or possibly the valuation as private equity looks at an investment.  What almost without exception the group of people that I spoke to said look hey, we know we are going to have to supplement management.  We are going to have to get a CFO on there.  My practical experience shows that the average client that I see has built a business because he is a real good sales person, or she, and they have executed against that but they don’t have the systems in place and they don’t have the CFO in place- so that’s real.  Rather than going out and patch together which I have done, you know you wait for the private equity group to get it done.  We did a decision on the West Coast a number of years ago, interesting business I started it from scratch, it was doing 20 million in revenue and the year before, 4 million, given that I had no real systems, I didn’t have the whole- it was being held hostage by a woman and a man, the system we started and she ran all these.  So to position this, to maximal [inaudible] we had to help them get away from being held hostage by its own employees.  You got some more formal staff in place.  The research here is maybe you don’t have to do that.  You just pull up to the private equity people, they know they are going to have to do this, you are upfront about it and say I need help here this is how I am going to add some value to it until you have some conversation about the value add, rather than trying to you know dance around it.  I thought that was pretty interesting.

Devin: That’s a really good insight because I do think a lot of people would say hey before I get into a process I got to look like I have got everything figured out, or I have got the team that they are going to back and you know I have experience too, will probably be adding a CFO, rarely replacing but adding a CFO because maybe there is a control or title to CFO but maybe they are more of a controller.

David: They are not CFO’s.

Devin: They were doing that probably doing that two thirds of the time and I know if you came to us with this, with one of your clients and say hey $20 million business we got growing nicely, we need a CFO and we know you guys are probably better equipped at getting the person you need in here than us, so we chose to to make that decision before you guys did.  I think, certainly I would say that’s pretty insightful, let us be part of this solution instead of having to unwind somebody you just hired 6 months ago.  I think that’s a good point.

David: On the West Coast we put a guy in, he didn’t last.  There is no way he is going to last, he lasted til we made a deal. I don’t know but that’s what, when I am seeing private equity guys 2 out of 3 of them say we know we are going to have to put finance people and they have done it, even with the stronger CFO’s they put somebody in place who is unstructured and who can get all ready for the monthly call and get the financial up and ready in the ten days that the private equity guys want to see it.  Most entrepreneurial businesses don’t do that.  That’s a major shift.  Another thing that’s pretty insightful for me was the view from a number of the [inaudible] look you know we have to put, we have to compliment management because they have only gotten where they are so clearly they haven’t been able to get to where we need them to be so they need help, they need support, they need replacement whatever.  Because as you know you guys are looking to take a business that is doing x and make it do 3x so you can get your exit, or 4x or 5x, but you don’t know how to get there with the existing people because they haven’t got what you want is the idea, the improvement, the relationships whatever, but you need to have the horse power to go forward.  So I advise my entrepreneurial client saying hey you know they are going to put somebody in here who you may report to, you have to get comfortable with that.  This job is to really accelerate your growth and that can be pretty uncomfortable, that is a major cognition that needs to be held and people will pay low service, that comes long as the deal really start to see how much has to happen for the investor to get a deal.

Devin: Yeah and that goes both ways right be careful what you wish for.  Bringing in somebody who has run a $50 million business into a $20 million business or a $100 million business into a $20 million dollar business knows the customers, doesn’t know the industry doesn’t know the team is coming in there as a hired gun.  Sometimes that works really well, sometimes it works out great because you get somebody who is steeply steeped in the industry and brings a lot of great ideas and innovation to the business.  It’s probably 50/5 if not you know 70/30, the team that got you there, I mean they know the business intimately, the know the product intimately and the customers intimately, and with a little bit of training and development you can get a lot out of the people who are already there and if you are buying a business where you don’t think the team can get you there, it might not be a business you want to buy, at least over my career.  Hired gun versus getting the most out of people you have got might be a coin flip and probably in favour of you got to work with the people you got because things move really fast these days and you got to make impacts very quickly because you aren’t stealing companies from people anymore right.  In the 80’s there were a lot of choices, entrepreneurs didn’t have choices, they didn’t understand the market. You know people were buying thing 5 or 6 times (?) now you are buying things for 8 9 10 times (?).  You don’t have time to do a redo on the management teams and hit your goals.  So you better have a way and a system to pour a lot of development and leadership training into that team and I am always surprised, there is always a handful of people in the business who are so good and so underutilized that once you kind of unleash that, and the founder and family have been uncomfortable learning that in terms of roles and responsibilities and reporting you get rid of some of the conflict that exists in the business to some degree.  You can really super charge these businesses.

David: Right that was made clear in a couple quotes. The other thing that was, and we are talking around here very well is that ultimately it’s how you develop a cultural fit within private equity and the management team going forward and does that exist, can it exist, how do you put it in place you know.  So who is- private equity wants to know who is going to stay, who are they going to build the team around? Are they going to supplement it? What are the strength and weaknesses, what is the brand value of the company they are buying and how do you fit all of these together.  The cultural piece you read about it all the time and the corporations, it’s probably in here as well.  It will allow investment to be successful and how you of that.

Devin: And often I think people are surprised how hard it is to change culture in a small business. There is sometimes way you know much harder to do it in a very big business.

David: Very difficult, I have personal experience with having tried to do that and its very challenging.

Devin: You have the scars to prove it, you will show me some?

David: Yeah exactly.  How you get change and the buy-in to do that.

Devin: David this was I am going to let you go here because we have been going for about 45 minutes which is good.  We are going to continue this conversation first over a beer next time I am in Atlanta, because I am there a lot, and second we will do another one of these conversations and get to the deeper into the cultural aspects of founder owned business you know getting ready for the process to go to a sale or a recapitalization of some sort.  Kind of all the things that go under there, giving entrepreneurs a toolkit or some guidelines how the can get ready what they can do, what they think is important for them and for me, as they make better clients for you and better partners for you.  I have the answers to the test before they get it which is part of the goal of this podcast and the blog we are doing at pefuncast.  So there will be a link up on the site to this paper, we will tweet it out as well when this is out.  So check the pefuncast twitter feed.  I am really happy you wrote this, I am really happy I read it.  This was a fun conversation David, and I don’t know who is more of a private equity geek you for writing this paper or me for reading it?

David: You for reading it..