Most of what I have compiled below is from studying different ways of valuing companies during my VC/PE days and working with some firms around their financial policies.
Relative Valuation
Most of the time when I visit classrooms and companies, the discussions stay very close to the DCF models, but the reality is that most assets are valued at a relative basis. What is relative valuation? It is valuing an asset by looking at how the market prices similar assets. It's the same way many of us value a house when we want to buy one in a certain area or location. We value comparables and market price per square foot. Sometimes we also look at relative views and quality within a house. Extending this analogy to assets, investors often decide whether a stock is cheap or expensive by comparing its pricing to other similar stocks.
In relative valuation, the value of an asset is derived from the pricing of comparable assets, standardized using a common variable. There can be many ways of segmenting relative valuation, but two of the most common ways is comparable and the other is standardized price. A good way to look at this is that, the price per share of a company is in some sense arbitrary since it is a function of the number of shares outstanding; a two-for-one stock split would halve the price. Dividing the price or market value by some measure that is related to that value will yield a standardized price. When valuing stocks, this essentially translates into using multiples where we divide the market value by earnings, book value, or revenues to arrive at an estimate.
However, to really perceive relative valuation, and in practice there are three variations that I have generally taken impression from; Direct Comparison, Peer Group Average, and Peer group average adjusted for differences.
Direct Comparison: Many industry professionals try to find one or two companies that look very similar to the company they are trying to value and estimate the value based on how these similar companies are priced. The key part in this analysis is identifying these similar companies and getting their market values.
Peer Group Advantage: Analysts compare how their company is priced with how the peer group is priced. A stock, therefore is considered cheap if it trades at 12 times earnings and the average price-earnings ratio for the sector is 15. Implicit in this approach is the assumption that while companies may vary widely across a sector, the average for the sector is representative for a typical company.
Peer Group Average Adjusted for Differences: There can be wide differences between the company being valued and other companies in the comparable firm groups, analysts sometimes try to control for differences between companies. In many cases, the control is very subjective. A company with higher expected growth than the industry will trade at a higher multiple than the industry average but how much higher is left subjectively unspecified. Sometimes, analysts explicitly try to control for difference between companies by adjusting the multiple used or by using statistical techniques. Consider price-earnings/growth (PEG) ratios. The ratios are computed by dividing P/E rations by expected growth rates, thus controlling for differences in growth and allowing analysts to compare companies with different growth rates. To a certain extent relative valuation judgments depend on how well we have picked the comparable companies and how good a job the market has done in pricing them.
Cheers. The cheers is for Kamo! ;)
Means of arriving at valuations: Part II of III
Means of arriving at valuations: Part I of III
Over the past few months, I have been working with a PE firm and have been guiding them on some valuation techniques for a specific region and industry that is not as standard and is not in the public markets, but rather in the secondary markets. I thought that it would be good to recap on some key ways of arriving at valuations, and what the pros and cons of many of them are. Many analysts and professionals in the financial space use a wide spectrum of models, ranging from the simple to the elegant. Models most often make very different assumptions about the fundamentals that determine value, but for the sake of my argument they do share common threads and can be classified into segments and lame terms.
The three valuation approaches that are most commonly used are DCF, Relative Valuation, and Contingent Claim Valuation. The first that I will dive into today, is discounted cash flow valuation (DCF). DCF is related to the value of an asset to the present value of expected future cash flows on that asset. The second, many people call is relative valuation which estimates the value of an asset by looking at the pricing of comparable assets, and relative to a common variable like earnings, cash flows, book value, and/or sales. The third, contingent claim valuation, uses pricing option models to measure the value of assets that share option characteristics.
Part I Pros and Cons of DCF:
For the true believers, DCF valuation is the only way. It's similar to the concept of jedi and sith. The benefits may be more nuanced then most believers are willing to admit. A pro, DCF requires analysts to understand the businesses that they are valuing and ask probing questions about the company's cash flows and risk associations. DCF valuation is great for those who follow the Warren Buffet philosophy that what we are buying are not stocks but the underlying businesses. In addition to that, the valuation is very contrarian in the sense that it forces analysts to look for the fundamentals that drive value rather than what the market perceptions are. Subsequently, if stock prices rise disproportionally relative to the underlying earnings and cash flows, DCF style modeling are likely to find stocks to be overvalued, and if they fall disproportionately, the model finds stock to be undervalued. How deep does that bullet lie?
There are, however, limitations with the DCF valuation. In the hands of a sloppy analyst, the valuation can be manipulated to generate estimates of value that have no relationship to intrinsic value. We also need substantially more information to value a company with DCF models, since we have to estimate cash flows, growth rates, and discount rates. Finally, DCF models may very well find every stock in a sector or even a market to be overvalued if market perceptions have run ahead of fundamentals. For portfolio managers and equity research analysts, who are required to find equities to buy even in the most overvalued markets, this creates a conundrum. They can go with their DCF valuations and conclude that everything is overvalued, which may put them out of business, or they can find an alternate approach that is more sensitive to market moods. It should come as no surprise that many of the best choose the latter.
When Founders are Concerned about Dilution
If you take a sample of 100 venture backed companies that have been successful enough to undertake an IPO, and you will find many of times a disturbing fact lodged in a high percentage of their prospects disclosures. The earliest stage investors (founders and angel investors)hold very small equity percentages and garner similarly small returns on their investment in the company. You could conclude that investors are entitles to the lushes rewards because of the high degree of risk accompanying their investment, but that is not the case. The problem, at the end of any point is the dilution. Most early stage companies go through multiple rounds of financing, and one or more of those rounds is often a "down round", which entails a disappointing price per share and significant dilution to those shareholders who are not in a position to play in the round.
The problem of dilution is mostly serious, because it has a major impact on angels and others who are thinking of financing, joining or otherwise contributing to a start up. One of the reasons why academic institutions have not been particularly successful in exploiting the technology they develop in their labs by taking equity in the companies licensing the same. When the liquidity event rolls around, the institution does not reep the benefits, such as the example of Stanford University and Google. There is some research that indicated the typical founding group winds up with roughly 8% percent of the company when the IPO usually goes effective. This is not a small amount by any means, but it is a very small percentage and it is nothing in comparison to the employee option pool, for example.
There have not been many obvious solution to this problem unless the venture investors and founders think through this a head of time. Well how many founders think through the end goal? It's almost near impossible because of the variable climate.
Getting the founder to bring the company to cash flow positive or break even at an early stage, avoids the necessities of Series B, C, and D rounds, but that chose is of course easier said than done. For founders who are also a part of the management team, participation in the employee option pool can help. Many of times the participation is eschewed by the founder on the theory that he/she has enough stock, but some would advise that founders should try and get as many of teh founders as possible into the option pool whenever possible.
Below is a visual graph of the valuation vs. timeline:
Valuation in a Down Market
During the bull market if the late 1990s, the United States guideline of "higher of market or cost" had allowed for pleasant surprises when portfolio companies went public or were acquired, as the market value almost always exceeded the value at which the companies were listed in the portfolio. As some LPs had observed "it was the world's worst time to try and establish guidelines" As the venture market came back to earth after March 200, private companies, unable to go public, found themselves compelled to raise new rounds at valuations that had fallen sharply from previous levels. Does this seem familiar with what is happening in 2008-2009?
For instance, one company had built up the management team, progressed well on product development, and secured a significant initial customer contract when it went into the market in 2001 seeking $80million at a $70million pre-money valuation. Despite this progress, the year before it had raised $60million at a $275million pre money value. Nor had the situation change a year later.
A company I was involved with recently, in the online media space, closed a $19million round in April 2009 but cut its post money valuation from $120million in its last round to $43million. It had little choice. The consequence was fairly simple, if you didn't do a down round, then the company would go out of business.
These issues have also proven challenging for LBO organizations. Unlike venture backed firms, which are typically refinanced on a twelve to eighteen month basis, most LBOs are not refinanced until they go public after the initial transaction. However, Groups tend to get tempted, to revalue the privately held firms in their portfolio. This can also be a very subjective process; for instance, in many cases, dramatically different results could emerge when a price to earnings rations or a market to book value multiple is used to value the firm. Many people argue that valuations are conservative because they use the same multiples that are used in the initial transaction. This assertion might be reasonable in a period of rising valuation, but the valuations of LBO transactions have fallen sharply in 2007, 2008. Although 2009 has started to see reasonable recovery.
These difficulties are not surprising. Private markets, despite lack of formal correlation statistics, are influenced by the public markets, at least directionally. Most private companies look to public enterprises to be their customers, partners, and acquirers. Falling public markets cheapen the stock that listed companies would use as a currency for acquisitions and restrict their access to financing. This in turn, makes the public firms cut back on capital expenditures and generally concentrate on their core businesses. Any private company valuation method that does not take the volatility of the public markets into consideration is doomed to be out of sync with true valuations.
While private equity has always been a cyclical business, several aspects of the recent market have made the cycles more noticeable. Previous market declines have never been as spectacular as the recent September 2008 financial crunch, at least in terms of the amount of money and number of LPs and GPs involved.
Secondary Markets
Much of the private equity activity in 2008 and the first half of 2009 has consisted of secondary purchases and sales of LP interests in PE funds. In the current economic climate, many existing investors in private equity funds are looking to sell their LP interests, including elimination of balance sheet liabilities associated with obligations to meet future capital calls and raising cash for funds.
In short this has caused a "buyers' market" in which institutional investors and new funds of funds with access to capital have the opportunity to buy private equity fund limited partnerships in the secondary market at discounts from face value. These discounts have been reported to be as high as 50 to 70 percent. In mid-April 2009, Goldman Sachs Asset Management closed on GS Vintage Fund V, its fifth such fund, with $5.5 billion to invest in private equity investments in the secondary market. Less than two weeks later, HarbourVest Partners, LLC closed on a new $2.9 billion fund for the same purpose. Recently, the Financial Times reported that JPMorgan Chase is raising a fund for the same purpose.
This alert summarizes the driving forces behind the increased activity in the secondary market for limited partnership interests in private equity funds and describes some of the important terms buyers, sellers, and general partners should anticipate.
Secondary Market Growth Factors
The growth of the secondary market for limited partnership interests in private equity funds is largely attributed to the economic downturn. Private equity funds are generally organized as partnerships, with the investors as limited partners and the fund manager as the general partner. Private equity fund securities are intended to be held for long-term investment by the original investor; funds typically have terms of 10 years or more and rarely offer redemption rights for their limited partners. Moreover, most funds provide for obligatory capital contributions throughout the fund life in response to capital calls from the general partner. Failure to meet such capital calls can give rise to severe penalties imposed on the defaulting limited partners, including the general partner's ability to:
1)discontinue future distributions to the defaulting limited partner
2)restrict the defaulting limited partner's ability to vote on limited partner issues
3)cause the defaulting limited partner to forfeit its interest in the fund
4)cause the limited partner to sell its interest in the fund to the fund's other limited partners at a discount.
In a growing economy, private equity funds often exit their earliest portfolio investments, via a sale or initial public offering, midway through the life of the fund, providing cash flow with which the limited partners can fund their remaining capital contributions or make new commitments to other funds. As the economy slows down and the credit and IPO markets tighten, it becomes more difficult for private equity funds to exit their investments in portfolio companies. This lack of liquidity is further exacerbated when the stock market experiences a substantial downward correction like the U.S. markets experienced in the first quarter of 2009. Limited partners who normally may be able to access the public markets to liquidate portions of their holdings to finance capital calls may not want to do so when the market is substantially down. As a result, many limited partners find themselves in the middle of the perfect storm with unfunded capital contribution obligations, which are recorded as balance sheet liabilities, and no liquid appreciated investments with which to fund these obligations. Thus, a sale of the limited partnership interests, accompanied by an assignment of the unfunded obligations, is often the best of several bad alternatives for the limited partner.
Even if the economy had not turned in the fourth quarter of 2008, the secondary market would likely have seen an increase in activity. Historically, the secondary market booms in the years following a boom in the primary market. And "boom" is exactly what happened in the primary market in 2006 and 2007. In 2007 alone, private equity funds invested nearly $700 billion globally, double the amount invested in 2005. In the same year, private equity funds raised an additional $500 billion of new capital. History correctly predicted that the secondary market's boom was not far behind.
The combination of the foregoing factors has resulted in the supply of private equity fund securities available for sale exceeding the capacity of those looking to purchase. Regardless of the reason for a seller entering the secondary market, many of the same issues will arise in negotiating the purchase and sale of equity interests on the secondary market.
What Terms to Look for in Secondary Market Transactions
The following deal points remain key provisions for secondary market sales:
Price. To calculate the purchase price, the parties typically fix a "cut-off date" as of a recent net asset value (NAV) determination. The parties then negotiate a premium or discount to NAV as of the cut-off date. In this market, except in very rare circumstances, the purchase price will likely be a discount to NAV.
Post-closing adjustments to price. Because the cut-off date and the closing rarely occur simultaneously, post-closing adjustments to the purchase price may be necessary. Any distributions by the fund to the seller will decrease the purchase price, since these funds would have been distributed to the buyer had the closing taken place on the cut-off date. Likewise, any funding of capital calls between the cutoff date and the closing will result in an increase to the purchase price, since this capital contribution would have been the buyer's responsibility had the closing taken place on the cut-off date.
Indemnification. As in any transfer of assets, indemnification will be an issue. A typical provision for a transaction in the secondary market will cover which party is responsible if a fund requires a return of distributions (sometimes referred to as a "clawback"). The appropriate allocation of responsibility for funding a clawback obligation may turn on whether the distributions being recalled were made prior to or after the cut-off date. Sometimes, however, a clawback will involve more than one distribution that straddled the cut-off date, in which case a pro rata return of distributions may be appropriate. As is common in other indemnification provisions, the parties may set maximum indemnification amounts and decide whether to use a "true basket" or a "tipping basket" provision.
Material adverse change clauses. As buyers have gained greater leverage in negotiations, material adverse change, or MAC, clauses are increasingly used as a condition to the buyer's obligation to close. Pursuant to a MAC clause, a buyer need not close a purchase of private equity interests if there has been a MAC. What constitutes a MAC, however, is a heavily negotiated point.
Side letters for buyers. Like MAC clauses, side letter requests increase when buyers have greater negotiating leverage in the secondary market. A side letter can cover nearly any topic, but the most common purpose for a side letter is to grant the buyer a seat on the fund's advisory committee. This provision, like other provisions discussed in this section, must be approved by the general partner. Unlike other provisions, however, this provision is likely to be a point of discussion between only the general partner and the buyer. A buyer will typically have leverage in these discussions, if the general partner has reason to be concerned that the seller might default on future capital calls, or if the buyer is viewed a likely investor in future funds (see "Staple transactions" below).
Staple transactions. While MAC clauses and side letters may be on the rise, so-called staple transactions are on the decline. Because general partners must consent to a transfer of equity interests from the seller to the buyer, general partners have traditionally had some leverage in negotiations. One way general partners have historically used that leverage is to require the buyer to commit to invest in the general partner's next fund. In this regard, the two transactions (one in the secondary market and one in the primary market) are "stapled" together. With the flood of sellers in the secondary market, however, general partners are in a weakened negotiating position. If a general partner wants a buyer with more caché, not to mention if the general partner wants a limited partner that can make its capital calls, the general partner is less likely to push for a staple transaction. Nevertheless, this is an important deal point that will likely come up in negotiations.
Future participation by sellers. Another deal term that is waning in popularity is the seller's right to continue to participate in distributions of the fund after the closing on the sale of the limited partnership interests. In 2003 and 2004, when the secondary market was more favorable for sellers than it is now, some sellers were able to negotiate the right to participate in the future "upside" of a fund. With the high supply of private equity interests in the secondary market, though, this provision has generally gone the way of the staple transaction.
Other issues will arise, including some that are similar between the primary and secondary markets. For example, each party will typically look for subscription-style representations and warranties from the other parties. The buyer in the secondary market should expect to be asked to represent that it is a sophisticated investor, that it is not subject to ERISA, and that it is an accredited investor for securities law purposes. Similarly, the seller in the secondary market, the fund, and the general partner of the fund should be prepared to represent that they have not run afoul of the securities laws prior to the contemplated transaction.
Private Equity Fuels Subprime in India
Microfinance, small business loans to the urban and rural poor, was originally conceived as a tool for poverty alleviation. It has become big business - and private equity has rushed in. The Wall Street Journal of August 13 reports that in India, private equity funds among other investors have "poured billions of dollars over the past few years into microfinance world-wide", using methods reminiscent of the aggressive, predatory lending which spawned the subprime debt bubble in the US. In India today, the article reports, "Some poor neighborhoods are being 'carpet-bombed' with loans" bearing interest of 24% to 39%.
India's urban and rural masses now find themselves caught in a pincer movement of indebtedness. While tens of thousands of Indian farmers now annually commit suicide because they are unable to pay off debts, the urban poor have become victims of loansharking on an expanded scale - and private equity is playing its part.
According to the WSJ, "Nationwide, average Indian household debt from microfinance lenders almost quintupled between 2004 and 2009, to about $135 from $27." The individual sums pale besides the trillions spent in the rich world's buyout spree, but the recipients of these loans frequently subsist on a dollar a day or less.
Access to greater funding for microloans has expanded exponentially as the big lenders of small loans have turned their backs on non-profit activity and registered as for profit financial service firms. Enter private equity: "Of the 54 private-equity deals (totaling $1.19 billion) in India's banking and finance sector in the past 18 months, microfinance accounted for 16 deals worth at least $245 million, according to Venture Intelligence, a Chennai-based private-equity research service.
"International private-equity funds started taking notice of Indian microfinance in March 2007. That's when Sequoia Capital, a venture-capital firm in Silicon Valley, participated in a $11.5 million share offering by SKS Microfinance Ltd. of Hyderabad, India, one of the world's largest microlenders.
"SKS showed the industry how to tap private equity to scale up," said Arun Natarajan of Venture Intelligence.
"Numerous deals followed with investors including Boston-based Sandstone Capital, San Francisco-based Valiant Capital, and SVB India Capital Partners, an affiliate of Silicon Valley Bank."
The World Bank-associated Consultative Group to Assist the Poor estimates global microfinance funds under management at over USD 6.5 billion - an estimate of how far it has travelled.
And as loan officers on commission rack up new loans, indebtedness has skyrocketed - from a few hundred million dollars in outstanding loans in 2004 to nearly USD 2.5 billion today, with the number of lenders increasing from 53 to 233.
private equity and assessing your portfolio companies
In light of recent events - my experience, economic conditions, and the continued downturn in the M&A/Credit markets, many PE funds have been focusing on stabilizing the health and value of their portfolio investments. This focus has come in many forms; From making small, add-on acquisitions in an effort to bolster the business, to spending more time on refining the underlying business operations.
Today's challenging economic environment and the generally limited ability of PE firms to use financial strategies to increase value requires a different approach by these firms to manage their portfolio investments.
This environment presents an excellent opportunity for firms to review their corporate governance approach, as there will be a greater emphasis placed on the ability to create value through board oversight.
Below are a few practical suggestions for best practices that private equity firms ought to consider in reviewing the corporate governance of their portfolio investments.
Board Composition
Board size, it is important to remember that, "no one size fits all." The appropriate board size depends on a number of factors, including the company's stage of development, the complexity of its business operations and the company's shareholder mix. However, sponsor-backed boards tend to be very hands-on and significantly involved with company operations, requiring a certain level of agility. Limiting the board to a maximum of five to six members makes agility possible and facilitates coordination of meetings and overall communication. Moreover, smaller boards tend to be more cohesive and work more effectively than larger boards.
With respect to the types of directors to elect to the board, seek out directors with relevant, hands-on operating and industry experience, particularly those with a specific area of expertise in an upcoming company initiative, such as a new product launch, entering a new market or an international expansion.
While there is often a desire to add multiple co-founders or executive management to the board, consider limiting the company insiders to the CEO and, perhaps, the CFO. The CEO can act as a representative of the other insiders and serve their interests, without the burden of adding a whole cast of characters to the board.
For a company considering a potential IPO, consider moving towards compliance with SEC and exchange rules regarding board composition and governance, including adding directors to the board who satisfy the various definitions of "independence." Finally, review the company's governance structure on an annual basis, and be both willing and prepared to implement changes that reflect the needs and growth of the company.
Board Agenda
In planning for board meetings, take time to consider and prepare the meeting agenda carefully. A well-planned agenda can make a big difference in the quality of a board meeting, serving a purpose beyond the mere content of the meeting by establishing the meeting's overall tone and pace.
The agenda should clearly articulate each topic, as well as the expected length of time to be devoted for each topic. There should be no surprises about what is to be discussed in the board meeting; rather, the agenda should be clear about what is being covered. Additionally, order the agenda so that the topics that are most important to discuss in the meeting are addressed first, to ensure that those topics are discussed in appropriate detail. Finally, consider circulating a draft agenda to the board in advance, soliciting feedback on the topics to be covered and confirm that the agenda covers areas that the board feels should be discussed.
Board Packages
In order for board members to fulfill their fiduciary duty of care, they need to be adequately informed about the decisions they are asked to make, as well as about overseeing the management of the company. The best source of information about the issues confronting the company is most commonly the company's management. As such, it is extremely important that management prepare and distribute, in advance of every board meeting, a well prepared board book along with the draft agenda, documents and financials for review and proposed resolutions.
Every board package should include the company's most recent financial reports, including the current budget, pipeline and year-to-date comparisons against the budget. Obviously, each industry will require its own, unique data. Significant attention should be given to the presentation of the data and consideration should be given to the board's unique circumstances (i.e., are the directors "financial experts" or, rather, more technically focused?). To the extent possible, put most of the data into a condensed, easy-to-read format. Distributing complete, articulate packages in advance of meetings can reduce the need for lengthy management presentations in most meetings so that maximum time is preserved for discussion.
Board Meetings
As with the board size, the number of meetings the board finds necessary depends on a number of factors, including the company's stage of development, the complexity of business operations and the company's culture. For earlier stage companies, consider holding eight to twelve meetings per year, with at least half of them in person. As a company grows and matures, the number of scheduled meetings will decrease, but should never fall below one each quarter, plus special meetings as needed. A regular dialogue will help keep the board members informed on the status and performance of the company, as well as ensure their engagement in the decision-making process.
When it comes time for the board meeting, take care to document the processes followed, and any decisions reached, by the Board. Carefully review all documents before approving them, and ask questions and probe and test all information that has been provided. Consider whether the advice of outside advisors, such as counsel or investment bankers, is appropriate. Also, consider the advice of the company's officers and employees, to the extent they possess information that is relevant to any particular decision. Finally, be sure to give all directors an opportunity to be heard, and confirm that all directors' questions have been addressed.
Executive Sessions
If the CEO serves on the board, then, immediately following meetings of the entire board, consider holding executive sessions without the CEO and other members of senior management present. These sessions can be a regular agenda item, either the first or last part of any meeting. The executive session enables the board to discuss sensitive issues or express their true feelings without jeopardizing the relationship with the CEO or senior management. However, not to defer important discussions to the executive session, as full and open discussion is important for the proper functioning of the full board. Consider having the lead director sit down with the CEO following the executive session and de-brief the CEO on what was discussed, so that there are no misunderstandings or suspicions.
Committees
The use of committees by portfolio company boards generally depends on the size of the board and the overall governance strategy of the sponsor. If the board consists of only a handful of directors, it is difficult to effectively distribute work among the board. However, in the case of larger boards, committees can be a valuable tool in improving the overall efficiency of the board by delegating tasks to those directors who can most efficiently do the work. With respect to governance strategy, some firms tend to run their portfolio companies entirely at the board level, whereas others view the board as responsible for broad strategic objectives, policy guidance and legally required matters, utilizing committees for monitoring and oversight.
If committees are utilized, a few guidelines should be considered. First, directors should not serve on more than two committees, to assure one or two directors are not undertaking the bulk of the board's work. Second, these committees should be made up of no more than four members, to maintain efficiency. Third, directors should be selected for committees based on their expertise and interests. Finally, the general advice concerning agendas, pre-read materials, meeting process and executive sessions set out above all apply equally to committee meetings.
Chairman/CEO Split
While institutional and activist shareholders have been increasingly advocating for separating the chairman and CEO roles of publicly held companies, private equity firms have long maintained their independence from the CEO of their portfolio companies by reserving the chairman role to a representative of the private equity firm. In so doing, private equity firms are able to preserve their objective judgment of management's performance, as well as promote a balance of governance power. However, the success of such a split is dependent on the individuals who hold these roles and how they work together. In order for the separation to be effective, it is important that the chair and CEO roles be clearly defined, and that the responsibilities and limits of each role be respected.
Identify Risks and Put in Place Oversight Procedures
A private equity firm's due diligence on its portfolio companies should not end with the closing of its acquisition. Rather, due diligence should continue into its initial ownership phase. Managers and employees are more likely to let their guards down and speak more freely about the business to their new owners once the keys have changed hands. As such, managers and other key employees should be interviewed and asked about specific risks they believe the company faces.
Once those risks are identified, put in place proper oversight procedures to carefully monitor those risks. For example, is there a risk of mismanaged inventory levels, creating excessive warehousing costs? If so, then implement an inventory management system. Is there a risk that accounts receivable days outstanding are being allowed to stretch too far? If so, then put trigger mechanisms in place that alert management when a customer's account becomes overextended, in an effort to minimize further exposure. Or rather, is there an internal risk that employee withholding taxes are being diverted? If so, then require management to submit quarterly withholding and payment reports. Also, consider borrowing a page from the Sarbanes-Oxley play book and have an officer certify as to the accuracy of such reports. Whatever the particular risk is, be sure that it is a risk that can be monitored.
Indeed, boards play a crucial role in providing oversight in the area of enterprise risk management (ERM). In an effort to improve the board's oversight of risk management, consider adding directors with a variety of expertise and proper risk management training. Also, in an effort to increase directors' ERM oversight, dedicate time at each board meeting to discuss various risk management relevant topics. Finally, identify those key executives who have the best perspective on the organization's risks and foster an ongoing dialogue among such individuals and the board.
developers and publishers in the traditional gaming world
In 2003, video game software sales across all gaming platforms exceeded eleven billion dollars. For the last three years game sales have generated more revenue than Hollywood, as box office revenues in 2003 were approximately nine billion. The game software segment of the video game industry is ruled by two major segments, the developers and the publishers. While both play a key role, major international publishers like Electronic Arts rule the industry in PC and console gaming, so we will examine that markonline PC games)
The publishers generally commission and pay for the development of a game, in much the same way that a television channel works with a production company to create a program. Because publishers have the finances to fund the majority of projects, they control which products reach the market, on what formats, and at what time of the year the games are released. Beyond commissioning the games, publishers often handle the marketing and distribution of games. Production includes the creation and manufacturing of the components, while distribution requires negotiating deals with retailers to get the title to consumers.
Figure Two below illustrates the video game software value chain. 
As a simple example of how the relationship between publisher and developer works consider the following. The developer gets a five million advance to create the game and ten percent royalty based on the publisher’s revenue following deductions. The developer will see royalties after the game has generated fifty million in revenue for the publisher. If a game sells for $30, it must sell one million units before the developer sees royalties. The video game software industry is dominated by large, international publishers, none more so than Electronic Arts (EA). Over the past three years the average company in the industry has seen an 8% increase in their stock price, while at the same time EA has increased by 123%. The following example shows the strength of position that EA holds. At the end of 2004, EA felt that it had lost market share to Take-Two Interactive and Sega Corporation’s ESPN NFL 2K5, a game in direct competition with EA’s Madden Football (the Madden franchise has generated over $1 billion in revenue over the last fifteen years). NFL 2K5 was aggressively priced at $19.95, less than half of EA’s title, basically resurrecting the ESPN football title. To counter this move by Take-Two, EA acquired the licensing rights of the NFL for all developing, publishing and distribution of interactive football games. This type of maneuvering is why we think this is a difficult segment for start ups. EA essentially locked out other publishers from producing NFL games for the next five
years, in similar fashion to deals EA has with professional soccer and golf (Tiger Woods). Because this industry is very mature and dominated by large international players, we feel that there is little opportunity for venture backed companies. It takes an enormous amount of capital to lock up the increasingly exclusive content and without such deals it will be hard for publishers to compete. Additionally, publishing is a segment characterized by strong relationships (with developers and retail outlets)and starting from scratch without these relationships would be extremely difficult. Further, there has been a large amount of consolidation in the market and starting a new console or PC game publisher is unlikely to be a lucrative business.
Developers
Software developers create the games that consumers will eventually play. The majority of software developers are independent companies, but some of the larger publishers have internal development teams or own a stake in external developers. In general the development process involves design, research, implementation, testing, and mastering. Games fall into three main categories, licenses, conversions, and originals, with developers tending to specialize in one segment. A licensed game is based on intellectual property that the publisher generally owns or has bought the rights to. A conversion is a game that has been developed for one game platform and converted to another. Finally, original games are based on a
developer’s concept. The majority of original ideas are created by independent publishers, who then try to get the game signed by a publisher. Original games are generally cheaper to produce because there is no licensing fee, but are riskier because of the uncertain consumer response to a new product. There are roughly 200 independent video game developers in the US today, with most working under the typical structure of an advance from a publisher as discussed above. This space is also dominated by the large publishers like EA who either control the game flow or develop games internally. Software development in the video game industry is an area likely to continue to grow at a strong pace, particularly in late 2005 and
early 2006 as new consoles are released (expected U.S. and European CAGR of 12%).
considerations of a market while starting a company
I recently started a company - and it is a bit different than what I have done previously, but its far more exciting and far more intense. Guess that's what happens when you play in the social media space. On the note of starting your own early stage venture, I have been catching up on the old ideals of customer development and iterative product cycles. I've been attending conferences to gain some insight before I take the large plunge with my new team. There are many resources on blogs, books, videos. Here are some of my thoughts around competing in markets with and without customers.
In competing in a very large market filled with a variety of legacy products as well as an increasing number of new entrants looking to re-segment and disrupt old ways of doing things and in a highly competitive or burgeoning market it can be dismaying to see new entrants burst onto the scene raising large rounds of financing. One should believe that their approach and features provide for a true competitive advantage over the competition. But, you have to be cautious as well to avoid common traps:
- becoming complacent by planning for the competition’s reality rather than its vision.
What do I mean by this? When a early stage startup or venture first conceptualizes a product, the team normally has a vision for what problem they’ll be solving is and how they will solve it. This vision is often hugely irrational,large in scale, and hugely ambitious.
Thus, executing on this vision becomes a game of engineering small chunks, launching, getting feedback and then engineering and creating some more. Achieving a vision is an iterative process and as the environment changes, so to will that vision.
Stealth startups enjoy the ability to be small and hugely agile. However, once customers enter the mix, the scope and the build cycles (i.e. executing on the vision) are slowed dramatically as customer usage leads to a whole new set of variables. As a result, a trap ("or shadow belief" - eric ries) for un-launched startups is to assume that the competition is light-years behind, lacks some insight, ingenuity or innovation simply because they don’t currently have a particular feature or approach.
As a stealth mode startup it’s all too easy to find one’s self executing on a road map that only assumes a competitor’s reality (their current product offering and features). Such assumptions are lethal; early ventures have to assume that the competition is always a day away from launching the same thing.
We have to remember that the competition also has grand visions. While we may think we have a competitive advantage in terms of an ability to rapidly execute and gain first mover advantage, the reality is that incumbents enjoy the true trump cards: a user base and a track record. At the end of the day ideas are worthless in a space. To be a true innovator involves not only having a great idea, but having the ability to execute on it. To remain a step-ahead, you have to plan and execute against the competition’s vision.
Lessons Learned!
I found this fascinating quote today:
And yet, it’s not really fair to ask that the company’s money be spent without anyone bothering to build a financial model that can be used to judge success. Certainly venture-backed startups don’t have this luxury – every business plan has a model in it. Just because entrepreneurs tend to forget about these models doesn’t mean their investors do. Companies that reliably fail to make their forecasted numbers are exceptionally prone to “management retooling.”Lessons Learned, Jun 2009
You should read the whole article.
