The US economy is in a constant state of reinvention. It’s just a part of what makes us “US” (forgive the pun). We’re an economy built around ideas and creation with a smattering of manufacturing, agriculture, and services. Keeping that delicate balance that supports long term stability and growth is a challenge, and ultimately the invisible hand is the best guide, in my opinion. In the mean time, we have to do what we can to keep that fog lifted and keep our economy nimble enough that it can dodge those jagged cliffs. Right now, the economy is fatigued and it is constrained. Not a good state for an entity that lives near the edge.

The Federal Reserve has hinted that they plan to increase credit availability to help harden the recover/softening in the second quarter. I mention both, because who you talk to depends on the answer you get.  This causes me to wonder–is credit the answer to all of our questions? Our problems right now are high unemployment and weak consumer demand. Will additional credit push start employers into increasing payroll and adding new staff? Does increased credit drive consumers to make additional purchases? To me, increasing credit is a “one trick pony” approach to solving the problem. Increasing credit is, to some extent, what got us in this situation in the first place. It’s like throwing 300 feet of rope to a man falling 100 feet to his demise.

I’m the cheerful pessimist because I love this country and have faith in its economy to adapt. I hope for the best, but I prepare for the worse and I think the bears will continue to control what’s happening for the next few months (6-18) if not longer. Unless something changes on the policy and leadership level, we should expect more of the same.

We came over to the show right about the time that The Whigs started their set. Unfortunately, the bass player had a personal issue and was unable to make this show. Since the band is a power trio (drums, bass, guitar/singer) they were seriously undermanned. The guitarist/singer did a few man-and-his-guitar songs that were pretty impressive, including a Sparklehorse cover. The drummer was selling merchandise in the back of the venue, but he joined for the last five songs. They recruited the tour manager for The Hold Steady on bass, and frankly, they sounded awesome. I’ve seen The Whigs a handful of times, and they never fail to impress. Even a man down, last night was no exception. These guys remain the standard for edgy power rock. They are great guys, very approachable, and just love their audience. There’s no fake angst, rocker fatigue, or ego with these guys. Just some great rock-n-roll. Check out this video for “Right Hand on My Heart”

When they finished and were leaving the stage, I told my buddy that I could have done with another hour of The Whigs. It’s the truth.

I wish I could say good things about The Hold Steady, and I’m sure they’re great, but the sound was so poorly mixed that it was painful. It was too loud (yes, that is possible), it was mixed poorly, and the band noise overpowered the singer. I mean you seriously couldn’t hear, let alone understand, the lead singer. As for the band, it just sounded like a bunch of noise and I don’t think I heard the keyboard after sound check. It was very disappointing because they seem like a great band, but they need to fire the sound guy. We left and walked down the street to another little hole-in-the-wall, where we chatted and listened to a local group.

Overall, The Whigs continue to rock… The Hold Steady may rock, but I have no way of knowing.

Doriot’s first principle is what I’ll call the “new factor.” Doriot believed that venture investments investments involve new technology, new marketing concepts, and/or new product applications. The driving force behind this policy is that venture investment needs something unique and novel that addresses an unmet need. The reason, of course, is a question of competition. If you’ve got the only solution, everyone with that problem has to come see and pay you for the remedy.

To understand the effect of having new technology, look at the effect of any modern industrial revolution. The gasoline powered engine disrupted so many traditional markets and economies from buggy whips to horse shoes. That’s the point of the “new factor,” you need something that disrupts in a life-altering way.  New product applications can recreate the life cycle of a technology. Do you think the original intention of the Internet was streaming video and digital music? There is probably no better example of new product applications that the internet and its seemingly unlimited number of applications.

The tricky part of this issue is not accepting the necessity of new technology or product applications. Those are relatively tangible ideas that we can wrap our minds around. The difficult part is understanding the role of a new marketing concept. A great case study for this discussion is hotmail.com. Hotmail, while an early email platform, was not the first of its kind. Its unique and competitive element, crated with the value-add of investor Tim Draper, was the creation of viral marketing through the email invitation system. Hotmail was one of the first platforms to do invitation only type services. Like most modern applications, invitation only is really not designed to choke off usability. Instead, its designed to force conversation about the product as people search for users in order to gain an invitation. It creates buzz and raises the profile, almost providing an air of exclusivity.

All entrepreneurial opportunities need some kind of “new factor” in order to capture and hold the market, but high-growth opportunities that seek venture investment need a life-shattering newness.

Next up, I’ll talk about the need of investors having a controlling interest in their investments.

Check it out.

Background

I previously wrote on this issue on December 10th. You can find that post here.

Also, here is a really solid post from Jason Mendelson, a VC (Foundry Group) in Builder, Colorado.

From the legislative perspective, a change to carried interest taxation from capital gains to ordinary income for all asset classes was included as a “pay for” in the Tax Extenders Act of 2009. This bill is designed to provide a short term tax break for big industry and passed the House of Representatives with a clause to increase taxes on carried itnerest for all asset classes. Fortunately, the senate version of the bill did not include carried interest as a revenue source. Unfortunately, the health care reform legislation that passed created a $30 billion shortfall and put carried interest as a pay-for provision back on the table since many of the identifiable sources of revenue have been fully tapped. Mind you, the Tax Extenders Act of 2009 was written to provide short term tax extensions for large corporations. Now, a long term tax penalty for those who foster small business growth and job creation is being presented as the solution. You can read more by visiting the public policy page for the National Venture Capital Association (NVCA).

More than 1,700 stakeholders from VC and start-up communities urge protecting VC carried interest. See press release from NVCA here.

More than 1,400 CEOs, company founders, and entrepreneurs support preserving capital gains tax status for VC carried interest. See press release from NVCA here.

How are VCs compensated? What is carried interest?

Let’s spend a couple paragraphs and provide a little perspective on compensation in the venture capital industry. Typically, senior staff (i.e. general partners, fund managers, etc) in a venture capital fund receive compensation in two ways. First, they receive an annual salary that compensates them at a base level. In my experience this is typically a healthy salary, but it may not be competitive with the salary many of these men and women would demand if they worked in other industries. Also, this compensation is taxed as ordinary income at 35%, just like the salary most anyone earns.

The larger motivator of performance for senior staff is the carried interest benefit (Investopedia article here) they receive on the returns of the fund. Most funds are structured in a way that all paid-in-capital is repaid to limited partners as a primary obligation, before the senior staff receive any payouts. After that principle amount is repaid, the remaining amount is split between the general partners and limited partners as “carried interest.” It’s important to note that their is no guarantee of this return, it typically occurs over a long period of time (8-12 years, by my estimate), but has unlimited potential upside based on the performance of the fund. This serves to keep the senior staff motivated to work for the long-term goals of fund performance. Currently, carried interest is taxed as capital gains at 15%. The rationale has been that this return is not guaranteed, is directly attributed to investment performance, and is earned over a long period of time.

To be clear, I am not “venture capital senior staff” but I’d like to be one day (in the not too distant future, hopefully). I’ve spent three years working in a venture fund, and while I’ve loved it, I’ve seen our senior staff work incredible hours into the late night and weekend, spend weeks at a time traveling, and do an excellent but difficult task of balancing their personal and professional lives. All of this is done for years without any guarantee that the long-term carried interest benefit will even materialize. I don’t want to provide some knee jerk commentary on how adjusting this tax rate effects my career plans, but this is certainly something I’ll be thinking about.

Why is this a big deal?

Aside from raising taxes an incredible 133% in a single action (would any industry do well with that kind of radical adjustment to its tax structure occurring overnight?) let’s look at the downstream effects of having a healthy venture capital economy. Venture capital backed companies represent more than 500,000 jobs in our country, and have added thousands of new positions each month through the recession. This is only a small piece of the pie, as it doesn’t even consider the publicly traded companies that originally received venture investment. Those companies–including HP, Microsoft, Apple, Xerox, etc–are estimated to represent 11% of America’s workforce. Take into consideration the thousands of smaller supporting companies that exist as a product of the industries these companies have created, and the over all economic impact is staggering. According to the Small Business Administration, over 60% of workers are employees of small businesses. What does all o this mean? According to a 2009 Global Insight study, venture-backed companies accounted for 12.1 million jobs and $2.9 trillion in revenue in the United States in 2008. America is envied across the globe for its economic engine because no other country has proven to be as innovative, and entrepreneurial. This gives America the flexibility, resilience, and strength that puts us in the driver’s seat for the world economy.

Some people take issue with the idea that multiple tax rates exist. For the sake of discussion and background, I’ll explain the theory of having a capital gains tax rate. The theory of capital gains is that we should encourage those activities that most spur stable long-term economic growth. Having a capital asset class that is dedicated to the creation and growth of companies is a critical part of accomplishing that goal. Allowing carried interest to be treated as capital gains allows rewards job and wealth creation, and it also allows more capital to be available for continued investing.

Ultimately, tweaking the economic model that drives venture capital investing is like cutting off your nose to spite your face. Trading off short term tax relief for big business on the back of long term tax burden to economic agents of entrepreneurship and small business doesn’t make sense. Where does most job growth come from? Small business. If you strangle off the agents that support small business, you effectively take a critical piece out of the entrepreneurship and small business ecosystem.

Don’t stream, who knows what the effect might be? There has been discussion by some of our foreign competitors to adjust their tax structures to completely exempt VCs from start-up investing. Would you like to see our economic engine gone to Russia and China? There is already data showing an increase in VC investment activity overseas.

Misconceptions

Venture capitalists did not cause the economic recession we are currently experiencing, but we have certainly felt the effects of it. I’ll let smarter and braver heads than mine go about explaining who did.

Venture capitalist do not operate the same as billion dollar hedge and buyout fund managers. We invest in private opportunities, not the public markets. We typically manage smaller amounts of capital and are highly involved and engaged in our investments. Our investments are small businesses with incredible potential. While many of them fail to survive the turmoil of being a start-up, the ones that do historically create jobs and wealth that greatly outweigh the losses.

Venture capitalists do pay ordinary income taxes on their salaries, the same as most every working man and woman. The capital gain tax status is assigned only to those returns earned as a result of effective investments. As I said before, the time horizon for these returns is long-term and undefined. In addition, there is no guarantee of these returns.

My thoughts–

I’m passionate about education, and this set of slides really captures some issues I’ve voiced about formal business education around the idea of entrepreneurship. To sum it up, you can’t use traditional pedagogy and expect to get entrepreneurs. While they need to know 80% of the material that a traditional business person knows, the other 20% is the “secret sauce” that doesn’t necessarily apply to big business.  This presentation captures this critique, hitting a home run around slide 38. While managerial accounting and operational strategy are key to success as an entrepreneur, that isn’t the “secret sauce” that drives entrepreneurial success. As I’ve come to understand, while traditional business acumen is necessary for entrepreneurship, it isn’t sufficient without the other 20%–the secret sauce.

I once heard a Dale Carnegie trainer describe successful leadership as a pyramid, with attitude, skills, and knowledge as the three sides. While attitude tends to be the base of the pyramid–after all, nobody cares what you know until they know you care–the sides are interconnected and rely on one another for support. I don’t believe that business schools can teach attitude, although they can encourage the right attitudes and discourage the wrong ones. They can manage expectations, assisting students with identifying their passion and lifestyle preference. Ultimately, those individual have to pull the trigger on a career. It has to be their passion, their idea, and their attitude that drives the business, particularly in the earlier stages of entrepreneurship, although I’d argue that is true for any business career.

The other two pieces of the pyramid are knowledge and skills. I consider knowledge to be the collected acumen for business and skill to be the ability to sift through that acumen and derive the relevant model/practice/content for making and implementing a decision. Business schools can expose students to this material around an entrepreneurial framework, but they need to do more. While big business may revolve around a relatively consistent set of best practices, almost every start-up is unique and requires unique skills. You need hypothesis testing, customer development, operational scaling, and an understanding of the appropriate and accurate performance metrics. All of these are, to some extent, unique to the start-up opportunity. Start-ups don’t have years of retained earnings to rely upon. There is no writing off bad and costly decisions as learning experiences. The loss of time and capital from bad decision making can forever alter the future of a start-up company, potentially causing it to cease operations. In my observations, successful entrepreneurs have an instinct for survival and paranoia that drives them to avoid those costly learning experiences. In contrast, those same entrepreneurs rely on data to understand the risk and appropriate approach for major business decisions. They see under-served markets, and if the opportunity is risk-reward appropriate, they develop a plan for attacking that market. The key is understanding if the risk-reward is appropriate and if a capital appropriate model can be developed. When you’re neck deep in accounting, logistics, etc, it’s difficult to step back and look at the big picture and get perspective around those types of questions. But, you have to know the accounting, logistics, etc to be able to address those types of issues.

To use a sports analogy, business schools make great athletes, but athletes need to find the sport that fits their talent and the position. Not all athletes are football players, let alone quarterbacks. Not all business school graduates are entrepreneurs, let alone high growth entrepreneurs.

Their are lots of folks in the East Tennessee area that are wrestling with this idea right now. The University of Tennessee has innovation/entrepreneurship programs in its business college for both undergraduates and graduate students. Out of the Garage is a blogging and learning platform under development by the guys at the Center for Entrepreneurial Growth.

I’m not sure where technology goes next with streaming content, but I think we have a convergence of traditional content and internet streaming in the not too distant future. Some how, entrepreneurs have to manage the dynamic environments of electronic devices (run for the hills, it’s the iPad) and streaming content. To top it off, we’ve got to build out the infrastructure to have the bandwidth to accomodate all of it. I’d expect a media mogul to attempt something like that, but the current generation is still trigger shy after Time Warner got slapped around with the AOL deal. Mind you, that parent owns HBO… so maybe we’re seeing some down road benefit of that catastrophe. Oh, and Google is also on the job (remember Google TiSP from 2007… yeah, it was a joke, but apparently they were thinking about connectivity to residential households).

If Netflix really wanted to put some pressure on the big media business, they should do a couple of things (in my not-so-humble opinion):

• Provide a rotating streaming big ticket picture on a weekly basis
• Provide the opportunity to stream weather and local media
• Provide streaming of live sporting events
• Build a library of musical performances

If we can keep technology and entrepreneurship on the tracks, we’ve got some real value-add developments coming. It takes a few years (late 90′s and early ’00′s) of stupid wasteful foolish risky ventures to help focus in on the viable opportunities. The show ponies are dieing off and the stallions are left behind. They may not get the attention of show ponies, but that’s because they’re stallions… they do –gasp– work. Our entrepreneurial communities aren’t dead, they’re focused on survival and committed to their concept. But enough of that, or I’ll start talking about the blasphemous and offensive fact that increasing government expenditure decreases small business growth and innovation.

I thought I’d write a few words about how I’ve prepared. I’ve looked over all the presenting companies and developed a short list of companies in our profile and/or that look attractive. I’ve reached out to most of those companies through emails or phone calls to make initial introductions. The way the conference is organized, their isn’t a real bullpen area where you can easily locate the companies. Plus, with so many potential investors in one place, it can be challenging to get the attention of folks. Even VCs get lost in the crowd when the crowd is other VCs. Same thing, if not more so, for entrepreneurs. I also plan to drop emails and calls to certain colleagues that tend to attend this event. It gives me an opportunity to catch-up with those folks, gaining valuable insight on how active they are and what areas they’re looking at.

After looking over the list of presenters, I noticed a few trends: lots of web-based platforms (i.e. accounts receivable, entertainment management, etc), lots of companies touting “cloud computing,” and a noticeably less “clean tech” companies. Make out of it what you will, but those are my observations. Also, here’s a good article on cloud computing that I stumbled across at Venture Beat.

Here’s some quick-and-dirty advice for presenting at one of these opportunities:

• You only get 5 minutes, so focus on the material the audience cares about. Sorry engineers and technologists, that probably doesn’t include CAD sketches and technical analysis.
• If you’re raising money, investors want to know– how will you make me money and how much money will you make me? Period. End of discussions. Please, no CAD sketches or technical analysis.
• Do not read off the slides. In fact, use the slides for context and support, not as the foundation of the presentation. Your personality, passion, and speaking should be the foundation.
• Investing is relationship driven, whether institutional or individual, so don’t forget to introduce and give context for your leadership team. But remember, you aren’t the product, so don’t act like it.
• Want other advice than mine, then checkout this post from Guy Kawasaki… The guy is an authority on presentations. Don’t believe me, just watch the video below:

Here’s a little laundry list of issues I’ve got with Toyota, most of them personal experience:

• I was given weather proof mats with the purchase of my car, to be shipped to my address. Two years later, still no mats.
• A few months after making the purchase and at 11,000 miles (1,000 miles over the 10,000 mile new purchase full warrant), the front bumper came unhitched from the wheel well. Mind you, this is cosmetic, but I expected the company to fix it. They did not, and quoted me a $800 price tag. Needless to say, I’ve learned to deal with it.
• Servicing the vehicle with the dealership has historically been expensive. The first 30k miles brought on a a couple of $250+ routine services. Even the routine oil changes were expensive at $50+. Over the last six months, the price of an oil change has fallen to around $30, much closer to my expectations.
• My little tray in the console between the front seats is stuck and won’t open. Apparently, a card of some type fell behind the latch, so I can’t get it open. Mostly cosmetic, but still very annoying.
• The company has 12 vehicles listed with a recall. 12… Really? I think we can call that a systemic issue at this point.

It’s a little early to criticize the company for its handling of the issue. After all, lets be honest, this isn’t an exploding gas tank problem. According to statistics from the company, over 80% of Toyota’s vehicles are still on the road after 20 years. I couldn’t even find Toyota listed when I googled for top ten automobile recalls (here’s one example). At this point, my issues isn’t with the company having recalls. My issue is with how poorly the company is handling the recalls. Here’s how the company has responded:

• Running a weak commercial
• A Washington Post Op-Ed by Toyota’s president of Toyota Motor Corporation
• A USA Today Op-Ed by president and COO of Toyota Motor Sales
• Shutting down operations at two US plants

I know the company is strong in its corporate culture, and maybe in Japan the brand carries enough strength to inspire confidence with consumers. But here in the US, we want to see executives stepping up to plate and taking responsibility for the problems. Failure to do just that it was drove many of us away from our own domestic car companies

Ultimately, I think Toyota is (hopefully) taking the right operational steps… but they are failing miserably in the PR department. I’ve almost reached my breaking point, between hearing about a new recall every morning on CNBC to listening to the talking heads opine about the issue in the evening. The company has to step up and reassure me as an existing customer. For me, that means some level of personal communication. It also means making a vehicle at an affordable price point that dominates in the quality and performance categories. Oh, and sending me my floor mats.

Clash of the Titans–Yes, I know it’s a remake, but the original was a favorite growing up as a boy. I remember watching it on TNT when spending the night at my Granny’s house. I recently asked/forced my wife to watch it and she made it through the whole movie, which is an accomplishment for her. I’m really hopeful that the remake is going to do it justice, and I think the special effects technology has reached the point of really giving us some cool scenes.

The Rum Diary–Hunter S. Thompson is someone that I’m fascinated with. His writing, his political views, his musical taste… all of it. Jonny Depp playing Hunter is even better (he played him in the film version of “Fear and Loathing in Las Vegas,” also). This is one of Thompson earlier books, before he got REALLY into the psychedelic drugs. It’s actually enjoyable without making excuses for the incredible talent hidden in sloppy jargon and syntax.

Jonah Hex--Two beautiful ideas meshed into a glorious product–comic book and western–in this post-confederate graphic novel. To boot, Megan Fox plays the gunslinging harlett and John Malovich plays the bad guy. Take your wife to this movie and you’ll probably lose move picking rights for a month… but it would be worth it.

The Wolfman–Also made my list in 2009, but release of the movie was delayed. This may be the movie I’m most excited about for 2010.  It’s another remake, but it looks fantastic. And the casting is incredible–Anthony Hopkins and Benetio Del Toro.

Tron Legacy-Combined with Clash of the Titans, 2010 is the year of movies from my childhood. If only Cloak and Dagger would make a return, but alas… The trailer looks awesome and the casting is true to the original. Also, the story sounds like a good way to explain the 30 years between the first and second movie. My only question, why make us wait so long?

Shutter Island–It’s hard for me to admit this, because I think DiCaprio is over rated, but this movie looks phenomenal. And after The Departed, I’m willing to accept that I may be wrong about DiCaprio. Murder, mystery, and Scorsese sounds too good to be true.

Robin Hood–I loved the original one, even with it’s cheesy Bryan Adams theme song, but this remake looks equally amazing. The casting is fantastic with Russell Crowe as the lead and Siene Miller as Maid Marrian (with a lot less emphasis on the maid portion than we’re used to). I get the feeling this will be a blockbuster budget action movie that will blur over some of the finer political points of the Robin Hood story… but I expect it will be so good that I’ll maybe forgive it. Did I mention Ridley Scott directs?

Honorable Mention: Alice in Wonderland looks like it will be beautiful in that Tim Burton kind of way; Iron Man 2 because RDJ was awesome in the first one and its hard to screw up a super hero movie with that solid of a lead; Toy Story 3 because they are that good, even for a kids movie; Harry Potter Part I of the Last Book and, yes, I’m glad they broke it into two movies.