Wednesday, April 28, 2010

Burning down the house

Goldman Sachs has been in the news much more than they would like and are bound to stay in this uncomfortable position for sometime. I have no idea whether this scrutiny is justified, or not, however, the age old conflict of interest monster is resurrected yet again. Over the past 20 years, much of the profits of Wall Street have shifted from gathering data, transforming it into information, which is then actionable by the firm's client. Today, much of the benefit from this data flow inures to the Wall Street firm, acting on its own behalf. With full disclosures, there is nothing wrong with this, and in many ways, it's the capitalistic way of life. But that does not make it right when you, as a client, find yourself on the opposite end of a trade, a transaction, or a bid from your advisor.

It's a trust issue. Plain and simple. In these cases, clients are not too interested in 'Chinese Walls', bolstered by regulations, when fundamental issues of self-interest arise when your competitor is your advisor. It gets your gander up enough to even think about uttering praise for the plaintiff's bar. Perhaps, all jokes aside they do serve as a conscience for the 'little guy'? At least, we know where they stand.

The subject of self-interest and trust comes up frequently in the venture business. One area, in particular, is around a M&A exit. Let me explain. Assume, as a VC, you have backed a CEO who owns 10% of the company and is 50% vested (with full acceleration on an exit). A private equity buyer approaches him and, with your consent, enters into sale discussions. The PE buyer, seeing the wonderful job he's done, puts on the table a wonderful CEO compensation package that post transaction refreshes his equity package (with options set at a value that reflects the acquisition cost).

The CEO, who works for shareholders that includes the VC firm(s) has a huge conflict of interest. He is charged with maximizing returns for existing shareholders, including himself, but has a MUCH greater incentive to gain personal liquidity and 'roll the dice' for another payday by serving a new group of investors. His self-interest is a conflict that the buyer recognizes and in many ways counts on to secure a favorable transaction. It's human nature.

If you've been through this before, a way to save the CEO and shareholders much angst, is to appoint a director as the point on valuation and structuring discussions. Remove the haze of conflict and replace it with a 'clean' transaction where everyone knows where self-interest lays. Understanding that most M&A approaches never reach consummation, it's also a good way to save the Company from much distraction, and the relationship from Burning Down the House.

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