Pro forma disease

Last night I attended the Fall New York Venture Edge Dinner attended by nearly 50 members of the NY venture community. In ad hoc remarks, Alan Patricoff expressed concern about the misalignment of the venture model (I assume he was referring to large funds chasing small(er) opportunities), Sita Vasan of Intel thinks there is great opportunity in front of us, and Venetia Kontogouris, of Trident Capital, is deeply worried about the economic environment.

The guest speaker was Daniel Gross of Newsweek, author of "Pop! Why Bubbles Are Great for the Economy" who gave a fascinating, informal talk about the election, bubbles and the general economic environment. On the election, he mentioned his recent article 'What's the matter with Greenwich?' where he cited that Mr. Obama carried the wealthy enclave of Greenwich, Ct. in the recent election, despite his intention to increase taxes for many households. He reflected that people were voting against their self-interest, then went on to observe that, in economic matters, Obama was shown consulting with luminaries such as Warren Buffet and Bob Rubin, while McCain had.....Joe the Plumber. Though they did not like the message, it seems they trusted the messenger more than his rival.

Mr. Gross's remarks about the economy were equally interesting. His last book examined the impact of past bubbles on our economy. Opining that bubbles are logical events in a world where human behavior suffers from episodic spurts of irrationality, he went on to explain that the net impact is not necessarily all bad. The past 150 years brought us Telegraph, Railroad,Internet and housing bubbles. Though investors who hung on too long, or entered too late, suffered great pain, the resulting infrastructure (rapid communications, seamless transportation, instant information) left our nation better off.

Towards the end of his conversation, a throwaway line really caught my attention. He said that we (I think he meant the general financial community) suffers from "pro-forma" disease. Pro-forma Wow! He sayeth the truth. We are in the time of year where CEO's and their management teams have put together neat budgets for board examination and approval. Each of these have bottom-up and top-down assumptions that are based on market dynamics, experience, and industry rules of thumbs. From a pro-forma perspective, they look great and from a governance view, are critical in a Company moving forward with a united front between investors and management. The problem is that we don't live in a pro forma world. Exogenous factors nearly always interfere with these best intents. Whether outside disruptions caused from competitors, markets, or technology shifts; or internal disruptions, emanating from personnel upheavals or process interruptions. It makes no difference, pro forma planning may be the best we have, but it's broken.

Budget slashing

It seems as if the first, and perhaps, last wave of systemic budget cutting brought on by the collapse of the financial services industry and pronouncements by stalwart venture firms, led by Sequoia are now behind us. Balancing the rush to preserve equity, often at the expense of equity creation, was a more balanced view expressed by Alan Patricoff.

In the venture business, there is always merit to surviving for another day. However, it's my experience that this is not the way to earn consistent returns for LP's, but a way to minimize capital exposure to under performing investments. Prudent companies, especially in our industry, led by folk who experienced the nuclear events of '01- '03, for the most part are not living way beyond their means today. One can always cut expenses, but our industry has consistently shown that creating equity value is most closely aligned with market share leadership. Moreover, the foundation for creating sustainable value, certainly in times of questionable exits, is by earning a volume of revenues, greater than your expenses.

Try as you may, but no young company, founded with a growth oriented DNA, that I remember, has ever slashed their expenses to victory. Many companies appropriately encouraged to slash budgets find themselves with now unproven markets, or a value proposition which has not yet resonated. Nevertheless, if a company has momentum, this environment presents an incredibly capital efficient time to garner market share as distribution, R&D and customer acquisition expenses are in a deep downward spiral.

The balance between growth objectives (often cash consuming) and balance sheet maintenance is what just shifted as the cost of capital soared by at least 30% in the past month. It takes a brave soul, full of passion and confidence to unabashedly continue with the leap into the unknown.

No doubt that some stakeholders will be massively rewarded for this confidence, it will take a few years to know just who...