Burnham's Beat

Infospace and the Great Shareholder Robbery of 2007

Wow.  Infospace reported earnings today and the stock was off 14%.  But that's not what's making me say "wow".  What's making me say "wow" is that I took this opportunity to take a look at Infospace's 2007 "earnings" report and I have to say I am impressed because it has to go down as one of the great shareholder robberies of all time.  Infospace, as you may recall, was a once high flying internet content company that assembled a motley menagerie of web and mobile based content businesses via 30+ acquisitions over the last 10 years.  They bought everything from Authorize.Net, to Go2Net, to Switchboard.  While there was supposedly a grand strategy driving to all these purchases, arguably what they were left with after 10 years and $1.7BN in paid in capital was just over $1BN in retained losses and a motley collection of business that looked like they were going no where fast.

Anyway, the company's mobile business was held out as the potential savior for a long time but as that too began to implode in 2006 and early 2007 the management team basically threw in the towel and embarked on a process of selling off the company's assets piece meal to the highest bidder.  No doubt a somber occasion given that the sales represented the culmination of a failed strategy that had cost shareholder's a cool $1BN, but at least you have to give the management team and the board credit for doing the honorable thing by admitting they failed and doing their best to salvage something for the shareholders.  Or do you...

On Closer Inspection
Before you give the management team and board any credit for doing the right thing, you might want to know a little something about the a deal they struck for themselves that nicely coincided with their fire sale.  The plan was to sell off the assets and dividend out the cash proceeds to the company's long suffering shareholders, which sounds fair enough.  However, the management team was able to convince the board that they should get paid a "bonus" equivalent to the dollar value of the dividends that would theoretically accrue to any vested or unvested stock options they might have.   So if the company did a $5 dividend of sale proceeds and the stock dropped $5 (which it inevitably would), the management team would get a $5/share bonus for each vested and unvested stock option they owned.

Now on one level that sounds fair enough.  I mean after all, why should the management team and the employees have their options go further underwater simply because they are doing the right thing and trying to get shareholders back some cash.  However the net effect of such a scheme is to basically give the management team a gross cut of whatever they sell an asset for without regard to whether or not the sale was even profitable.   The cynic/economist/anyone with common sense would say that under such a incentive structure management would race out and sell everything and the kitchen sink for whatever price they could get because it was money in their pocket no matter what.

Care to guess what happened?

Everything Must Go!
That's right, Infospace's management team ran out and sold everything they could for whatever price they could get.  The directory business, painstakingly built up over a period of 10 years: sold for $225M to a private equity firm.  The mobile business, which they been acquiring new businesses for less than a year earlier: sold for $135M to a private competitor (who reportedly now mightily regrets the purchase).

And what did they do with all that cash (as well some cash from settling a lawsuit with a former founder who defrauded the company's investors)? Why surprise, surprise, they dividended out all that cash out to their shareholders in two special dividends totaling $15.30/share or over $500M in cold hard cash.

And what, pray tell, what did the management team get for the arduous task of lifting up the phone and calling their bankers?  A cool $90M in special cash bonuses and stock compensation in 2007.  If you are on that management team, the thought that likely came to mind as you cashed your 2007 bonus check was "God Bless America!"

Defending the Indefensible
But wait, defenders of the management team's "golden dividend" might point out that the asset sales generated a combined $149M "gain" and surely the team should at least be entitled to share some of that gain.  But that logic fails to account for that fact that prior to 2007, Infospace had already taken $240M in impairment charges since 2000 which means that the actual "gain" on sale of those assets was likely far lower and might even have been a net loss of over $90M on an original cost basis. (I'd guarantee its a loss, but it's impossible to figure out what impaired assets were sold given how many deals they did.)

One final point of defense might be the stock price.  Defenders might point out that at the beginning of 2007, before management embarked on the asset sale strategy, Infospace's stock price was $20.51, and even though it closed at $10.38 today, when you add back the $15.30 in dividends, you get an adjusted price of $25.68 or about $5.17 higher, so one could argue that despite all the management payouts they still created value.  There are only two problems with that logic:  1.  With 33 million shares outstanding, $5.17/share translates into only $170M in increased "shareholder value" vs. $90M in management comp which equates to a 35% cut for the management team.  M&A bankers would sell their mothers to get a 3% cut of a sale so I shudder think what they'd do for a 35% cut.  2.  If you go back just 3 years, the stock price was at a whopping $47.55 meaning that shareholders have suffered a 46% loss in the last 3 years, but the management team and the board thinks that's an occasion for them to give themselves a windfall payday the size of which would make even an investment banker blush.

Don't Look Now But You've Been Robbed
Let me be clear: I've never owned or shorted (unfortunately) Infospace stock, so I don't really have a dog in this fight.  I am just flabbergasted that none of their shareholders stood up to such a blatant scheme and called it for what it is: highway robbery.  I don't have a problem at all with paying management teams well for creating value,  I just have a huge problem with handing out huge bonuses (i.e. more than 10X the already egregious fees charged by bankers) to people who sell assets for little if any gain when their shareholders are already sitting on $1BN an losses and a 46% stock depreciation since 2005.  Call me crazy, but I have a problem with that even if, inexplicably, Infospace's shareholders don't.  You may also ask why didn't the board, who supposedly represents the shareholders, have problem with that: simple, they cut the same deal for themselves.

As for shareholders, they are now left with a business whose only significant asset is a website called Dog Pile.  If you're like me, the image that pops into your mind when you hear the term "Dog Pile" isn't exactly a pile of money, which at least strikes me as poetic justice if nothing else.

I currently have no investment position, long or short, in Infospace.  This is not investment advice, it is an incredulous rant.  Please see my disclaimer at the bottom of this page for further details.

SkyGrid and the Emergence of Flow-Based Search

GigaOm had a post today on a company called SkyGrid and its official company launch.  As an investor, advisor, and beta-user of the platform, I thought I would chime in with my own self-serving post mostly because I wanted to talk about the advanced technology and architecture behind SkyGrid and why it makes the company such an interesting case study in the evolution of search technology.

Simply put, SkyGrid represents a massive and exciting departure from traditional search architectures and technologies.  If I had to sum it up in a word, I would say that SkyGrid represents what I consider to be one of the first "flow based" search architectures, while traditional search engines are "crawl based" architectures.

Old Search: Crawl/Index/Query
While the technical departure was necessitated by the leading edge demands of investment professionals, it was these needs, and the lack of traditional search's ability to meet them, that exposed some of the most glaring weaknesses of traditional search technology. Specially, traditional search technology and architectures suffer from several glaring weaknesses:

1. Crawl-based: Current search architectures collect information to index primarily by employing massive farms of "crawlers" that systematically crawl IP address spaces. The benefit of crawling is that it is exhaustive, the drawback is that it time consuming and expensive.
2. One-off: Search platforms are designed around rapidly processing one off queries. This makes search engines highly useful and adept at finding "the needle in the haystack" but very cumbersome to use in situations where one just wants to get new results to the same old query.
   
3. Batch-based: Page rank and the other "secret sauce"algorithms behind most search engines today require a very expensive and complicated indexing process to be performed on "snap shots" of data. It can be days or even weeks before newly published content is crawled and properly indexed, meaning that most search engines fail to provide "real time" results for all but the most popular content sources (which they crawl very frequently).
   
4. Unabridged: Search engines are exhaustive in that they return every URL that mentions a string. This is good is you are looking for a needle in the haystack, but bad if you are trying to search on a common term such as "Google" or "Microsoft". While ranking algorithms do a great job of ordering results according to likely relevancy, they don't filter down the number of results. Since most users don't go past the first page of results, this makes it quite easy to miss relevant information that for some reason doesn't rank in the top 10 results.
   
5. Unstructured: Search engines typically present query results as a simple list without context or analytics, beyond say separating them by a simple criteria, such as text and images. While some progress has been made in terms of trying to cluster results or help users filter them, by and large, users still just get an unprocessed, unanalyzed data dump when they do a search.
   
6. Retrospective: Search today is focused on determining what has happened in the past. Who wrote what, who said what, etc. However this does little to help people figure out what will happen in the future.
   

Without giving away the farm, SkyGrid represents an exciting departure from the search technologies and architectures of the past. This change has been made possible by several factors including the widespread deployment and adoption of ping servers and RSS/ATOM feeds, dramatic improvement in several areas of artificial intelligence and unstructured data analytics, and new stream-based methods of database and query design.

SkyGrid Search: Flow/Filter/Analyze
When you put all of these technologies together, along with a laser like focus on solving some of the unique high-end demands of investment professionals, you get a radical new search architecture and technology that not only solves some very pressing and pragmatic problems facing investors, but holds the potential to actually predict the pattern and influence of idea/meme propagation throughout the internet and from there into the financial markets and beyond.  

Specifically, SkyGrid's search architecture differs from traditional search engines in that it is:

1. Flow-based: SkyGrid treats the web as a giant pub-sub system or at least it does to the extent that the rapidly growing RSS/Ping server infrastructure does. It does not crawl the web, but rather the web "flows" to it.
2. Persistent:  SkyGrid persists queries over time so that incremental results are delivered with no additional action by the user. One can easily see how this would be valuable in the case of something like, oh say, a stock, which persists from day to day.
   
3. Real-time: Rather than using batch-based indexing, SkyGrid uses a real-time stream-like query system that queries (and analyzes) new content as it flows into the system. This is particularly useful in situations, such as investing, where a few minutes or seconds, can make a huge economic difference.
   
4. Filtered: Rather than presenting results as a data-dump, SkyGrid uses advanced analytics in the form of entity extraction, meta-data analytics, and rules based AI, to quickly analyze and append additional meta-data to incoming information. This enables users to easily filter data according to number of criteria which greatly lessens the chance of "data overload" and greatly improves the chance of "data discovery".
   
5. Analytical: By applying highly advanced artificial intelligence, such as natural language procession, entity extraction, etc. SkyGrid is able to actually analyze and assess the actual content of a URL, thus enabling it to make determinations such as the sentiment (positive/negative) of information, its "velocity" and its "authority". This goes a step beyond simple meta-data filtering to creating real insights into the content.
   
6. Predictive: SkyGrid's flow based architecture and advanced analytics enable it to view the web as a living breathing, changing entity. By observing the propagation of information over time and across downstream nodes, SkyGrid is in a position to not only assess the "authority" and "influence" of individual nodes, but it should ultimately be able to make reasonable predictions about which information will flow where on the web. By correlating this observed "flow" over time with observed movements in things such as, oh say, stock markets, company sales, etc. it can not only assess the historical sensitivity of changes on the web creating changes in the real world, but it should ultimately be able to theoretically predict, with reasonable accuracy, many of those changes. Yes, I said it: SkyGrid and its new search architecture may ultimately predict the future.

I realize that the last point is at the very least hyperbolic and at worst disingenuous, but as an early beta-user I can tell you first hand that once you see it in action and understand the architecture, predicting the future, in some very specific, limited, yet potentially highly valuable ways, is certainly not something beyond the realm of reason and indeed something that seems quite possible given the progress to date. That said, SkyGrid is still a beta platform and many features have yet to be implemented in part or in full, but the promise and potential is undeniably there.

Google Roadkill?
Why won't SkyGrid simply be put of business by the big players like so many other search oriented start-ups? First and foremost because SkyGrid is delivering a premium product to a group of users that will pay significant sums for something that not only dramatically improves their daily productivity but holds out the promise of providing insightful, market oriented analytics that they simply can't get elsewhere. Second, the existing search engines cannot compete effectively against SkyGrid because to do so would require a reengineering of their basic search architectures to address all of their shortcomings relative to SkyGrid. Moving from a traditional crawl/index/query architecture to a flow/filter/analyze one is a decidedly non-trivial undertaking, one that would require an entire re-architecture of their core services and thus one highly unlikely to be made.  

Well then does that mean that SkyGrid will put the "legacy" search engines out of business? Not at all. The current search engines are optimized to deal incredibly well with the vast majority of queries from the vast majority of users and they will likely continue to do so for some time. Next generation flow-based platforms such as SkyGrid are, by design, tackling a subset of the available queries, but arguably a very valuable subset. Indeed that's why SkyGrid can charge $500/seat/month for its services while the existing search engines must give away their services for fee and make their money on advertising.

Now I can see a lot of people being skeptical after reading this about both my ability to impartially judge SkyGrid's next generation search technology as well as its market potential. To them I would say: just keep your eyes out for some announcements over the next month as I think they will conclusively demonstrate that a number of people far more knowledgeable and accomplished than I see the same potential.

Fortune Magazine Fight Fest: Private Equity vs. VC

Just came back from a lunch for about 50 people that Adam Lashinsky of Fortune Magazine hosted.  The topic de jour was the whole carried interest taxation debate.  Adam moderated a great panel that included Mike Moritz from Sequoia, Dave Roux of Silver Lake and Prof. Darryll Jones, a tax law expert.

The panel had some pretty interesting things to say and also revealed some very stark divisions amongst the various players in the carried interest drama.  A few quick take aways:

1. Surprisingly, it seemed like the biggest debate took place not between the investors and the Professor, who was outright opposed to any capital gains break for carried interest, but between Roux, a private equity guy, and Mortiz, the VC.  Mortiz took great pains to distance Venture Capital from private equity while Roux tried to argue that the two basically did the same thing, albeit for different stage companies.
   
2. Between Mortiz's comments and those from Ted Schlein (the current head of the NVCA, who was sitting at one of the tables) it's crystal clear that A) the NVCA believes some kind of legislation on this issue is going to pass (probably by December) and B) they are moving as hard and fast as they can to try and cut their own deal with Congress that exempts Venture Capital from some or all of the tax increases (while presumably still sticking it to Stephen  Schwarzmam & Co.) Personally I think the "every man for himself" strategy being followed by the NVCA is a mistake.  Political fights are won by horse trading enough to build as big and broad a coalition as possible and as such the NVCA should be trying to pull more groups into the fight (especially small business owners), not selling everyone else out in the hopes that some kind of high minded argument about the "public good" of venture capital vs. other kinds of investment capital wins the day.  The politicians are looking for money and votes and the only way to win that fight is to fight fire with fire.  That said, it will be very interesting to see if the NVCA's gambit pays off and one has to imagine that the NVCA wouldn't be pursuing this strategy if they didn't have a bunch of votes already lined up for it.  My guess is that it won't work and all the NVCA will have to show for it is a lot of pissed off Private Equity guys, but I also hope that I am wrong!  Kind of ironic given that the lines between the two industries seem to blur daily, but for now the battle lines are clearly drawn.
3. The curent wild card in the debate appears to be that the Joint Tax Committee has yet to report on how much money they expect the proposed changes to carried interest will add to the treasury.  Prof. Jones said one early estimate out of the University of Pennsylvania was that the changes would only add $2-$3BN in tax revenue/year and that was before any strategies were devised for avoiding the new taxes.  This is important because many Congressmen are apparently hoping that this change will offset most if not all of the $50BN in taxes lost to a likely AMT tax repeal.  However if changing the carried interest provisions only generates a few billion in revenues, the political calculus is likely to get a lot tougher for Congressmen because they will risk alienating a decent number of their best campaign contributors to generate what, from the government's perspective, is a tiny piece of revenue that doesn't even come close to solving their main political problem.  Thus it would appear to me that in the near term the single most important thing to watch out for in this debate is just how much cash the committee estimates the proposed tax changes will generate.
4. I continue to be struck by the fact that the "pro-tax" side of this debate, is basically taking a position which denigrates Labor at the expense of Capital. Prof. Jones was actually the first person I've seen on this side to express some reservations on this point, but besides him almost everyone else on that side of debate seems to be oblivious of the tremendous irony and contradictions inherent in their position.  As is often the case in politics, principles are no match for money.
5. One other interesting thing to note:  I asked the Prof. if a VC should have to pay ordinary income tax on carried interest even if they received no salary or cash compensation at all, and he said "yes" because the carry was still compensation for labor, even if it was delayed and at risk.  Then I asked if that same reasoning applied to entrepreneurs, i.e., should entrepreneurs that invest time/effort/IP have to pay ordinary income on the profits from sales of their stock and he once again said "yes" because, just like VC's, this was compensation for services provided, not capital.   I give the Professor a lot of credit for being logically consistent, because it seems crystal clear to me that those who advocate eliminating capital gains for carried interest are logically compelled to have the same position when it comes to other forms of sweat/intangible equity, but I think the Professor is one of the few people on that side of the debate that have the courage to be upfront with the logical consequences of their position.  Based on this, it's clear to me more than ever, that the carried interest debate is just a prelude to eliminating the concept of sweat equity/intangible capital from the tax code altogether.  This means that entrepreneurs laughing at the sight of "rich" VCs trying to maintain their cushy tax breaks had better stop laughing because you guys are clearly next on the hit list.  Don't believe me, just do the math:  would the government generate more revenue by taxing all the profits generated by all the people who get sweat equity stock or all the 20% of the profits generated by VCs who get carried interest?  Before you answer this consider that if you changed the tax treatment for "founding stock" to ordinary income than the Google Founders alone would generate at least another $4BN in incremental taxes on their $20BN+ stake.  Doesn't take Einstein to figure out what's the quicker way to fill a $50BN hole.

Software and Internet IPO and M&A Lists

Every month I keep a record of all significant public company activity in the sectors I am most interested  in: Software & Internet.   I keep records of all IPOs in those sectors as well as all public company M&A.  I've decided to try out Typepad's relatively new "page" feature by open sourcing these transaction lists.

The links should be good forever and I will try to update the lists each month as I already do this internally.  The lists start in 2004 and are current as of 5/30/07.  Recently announced M&A deals are not listed because they have yet to close.  It's kind of fun to take a walk down memory lane, and see just what has happened over the last few years in each sector.  So without further ado here are the lists:

Internet IPOs
Internet M&A
Software IPOs
Software M&A

If you see anything missing or anything that needs a correction just e-mail me.

Yahoo Buys Rivals From $75M More Than Their 2001 Offer

Yahoo apparently agreed to buy Rivals.com for $100M today and that brought me back down memory lane a bit, so I thought I would share.  In Q1 2001, Rivals was hemorrhaging cash and appeared to be on its last legs.  The site was still attracting a lot of traffic and producing very high quality content, it's just that their cost structure was way to high.  At the time, Yahoo stepped in an offered to buy Rivals for $25M in cash but they proposed a incredibly complex structure designed to somehow keep the near term losses off of their books.  That deal fell through (like so many "rescue attempts" did in 2001) and the company was basically liquidated by the VCs.

Fast forward 6 years later and Yahoo is laying out $100M in cash for a newly revived Rivals.  From what I understand, the founder bought out all the assets in 2001 and restarted the company with a non-bubble cost structure and mentality.  Six years later he is rich man and Yahoo is out an additional $75M because they let a bad cost structure distract them from the reality of a great product.

For me, a deal like Rivals reinforces some great investment lessons:

1)  Even if good products are damaged by bad business decisions, they are still good products.
2)  The time to buy is when everyone else is selling.
3)  You can always reduce expense more.
4)  Don't give up on a good product too soon.

Congrats to any of the original Rivals team for sticking it out.  That's what being a passionate entrepreneur is all about.

The Tax Man Cometh: Carried Interest, Risk, Fees, and Taxes

So there’s a move a foot by some within Congress to tax all carried interest as ordinary income instead of capital gains.  In case you aren’t familiar with the term, carried interest is the share of profits that the general partner within a limited partnership receives. Traditionally, all of the profits generated by a partnership  have been treated as capital gains so long as the investments that generated the profits have been held at least a year.  This means that general partners in VC, Private Equity, or Hedge funds (funds which typically are structured with a carried interest) not only get highly leveraged returns on their own investments, but that any profits produced get very favorable tax treatment (15% vs. 35%).

A Bad Way To Deal With An Admitted Problem
Originally I was going to write a post about how this idea would require a complete rewrite of the tax code and how at its heart it’s a Marxist attack on capitalism, but I figure that A) it would be seen as entirely self serving (which to some degree it is)  B) I don’t think it’s going to happen as currently envisioned given how many feet the government has to step on to make this change happen.

However the more I thought about it, I think it should honestly be said that the proponents of such measures have a few decent points which I think that the entire investment community, in an honest moment of reflection, should probably admit as valid.

Before I do so, let me first state that it would be crazy (and highly impractical/improbable) for the government to enact a blanket change to the tax treatment of the profits generated by the General Partner in a Limited Partnership.  Limited partnerships exist for a very good reason: they are an efficient vehicle for making highly productive capital investments that generate future economic growth and tax revenue.   This growth effect is why Limited Partnership investments and most other forms of capital investment, very sensibly, get favored tax treatment.  In a country with a negative savings rate, we need to do all we can to spur investment.  In addition, while the General Partner’s clearly get great leverage on their investment (usually 20/1 sometimes even 50/1), they are not just risking their own capital, but they are making a substantial investment of “sweat equity” which the limited partners obviously feel is very valuable.  If general partner’s are prepared to take the risk of a 100% loss on not just their money but also their “sweat equity”, there’s really no reason in a capitalist society why their investment shouldn’t be treated like any other capital investment.

Risk Based Investing Without The Risk
That said, as fund sizes have exploded in the last 5 to 10 years, the level of risk that the General Partner is really taking has arguably declined dramatically because the fee income for many funds has become so huge that many of the general partner’s will make a ton of money even if their fund is a total disaster.   After all, it’s hard to claim you are risking a lot of “sweat equity” when you are driving around in an air conditioned Bentley.

For example, in the VC industry if you go back to 1990, according to the NVCA the average firm size was $82M and they had an average of just over 10 “principals” at the firm (10.2 to be precise).  With a 2% management fee, that pencils out to about $164K in management fee revenue per principal, and that’s before all operating expenses.  With fund sizes this small, the general partners were clearly not living high on the hog when it came to management fees.  In fact, if the funds didn’t make a decent profit it would be safe to say that the opportunity costs for most of the partners at the funds would have far outweighed any fund returns.

By 2002, the average firm size had risen to $284M, but the average principals per fund had actually dropped to 9.5.  Five years later I don’t know what the exact figures are, but my guess is that the average is now above $300M and the number of principals has either stayed constant or gone down, but average management fee is now probably closer to 2.5%.  What that means is that at the average firm now generates $789K/year in management fees per principal and many of the top firms (ones in the so-called 3/30 club) have funds under management of well in excess of $1BN, 3% management fees and just 5-10 full partners.  Such funds can and do pay their partners $2-$3M a year before the investors get a single penny back.  Many of these funds also pay the capital contributions of their partners out of management fees meaning that the individual partner’s never even have to write a check into the fund.

Under these circumstances it’s not hard to see how venture capital has become a fairly riskless proposition for many GPs and that it’s pretty hard to argue folks are investing a lot of sweat equity when they are pulling down at least a million dollars a year for getting out of bed in the morning.  Put another way, in a 3/30 $1BN fund, the general partner only has to put up $10M but in return is guaranteed to get at least $150M in fees over just the next 5 years.  With numbers like that, it’s hard to argue that the partner’s are really taking any risk at all and if they aren’t taking any risk then why in the world should they get any favorable tax treatment for their “sweat” equity since they clearly aren’t sweating the risk of a loss.  If they do lose their share of the $10M they can just fly in their private jet to their beach house Maui to console themselves.  The situation is even more pronounced in the private equity world where fund sizes are now racing past $10BN.  At this level, the compensation for partners at many private equity fund’s makes VCs look downright parsimonious.

So while I agree with and strenuously defend the principle of affording capital gains treatment to those general partners that are willing to take the risk of investing their own cash and sweat equity to produce returns, I think the reality is that in a large number of institutional funds today (be they VC, Private Equity or Hedge Funds), the principals are really not risking much if anything and are pretty handsomely compensated for the time and energy they spend on their portfolio investments.

A Modest Proposal
All that said, the solution that government is proposing is, as usual, terribly misguided.   Taxing all income to general partners as ordinary income is a sure way to A) unfairly penalize those limited partnerships where the general partner really is taking a significant risk and investing a lot of sweat equity (which usually are small business partnerships focused on things such as restaurants and apartment buildings) B) reduce the overall level of private investment C) hurt the businesses that depend on this investment capital for growth.  While I think that a blanket change in the tax treatment is bound to have these negative effects, there are some other changes Congress can make which insure that general partners really are taking real risk and investing real sweat equity to help growth the economy such as:

1. For tax purposes, reduce the general partner’s tax basis by the amount of after-tax management fees it pays out to its members.  In other words, if an individual partner invests $1M in the fund, but gets a salary from the fund that generates an after tax income of $1M, then that individual’s basis should be reduced to zero, which effectively means they invested nothing and should therefore have to pay ordinary income taxes.
2. Raise the % of the fund that the general partner needs to contribute to qualify before it qualifies for capital gains treatment from 1% to 5%.   This makes the level of risk for the general partner a lot more meaningful.  One major drawback of this approach though is that general partner’s without a lot of cash will be hard pressed to meet stiffer capital requirement and this might unfairly advantage old rich firms over new upcoming ones.
3. Some combination of 1 and 2.

These changes increase the level of risk and neutralize the risk reducing effects of copious management fees.  Firms can still choose to pay their partners a ton of money, but if they do those people will lose favorable tax treatment on their investments unless they are willing to invest a lot more cash.  This kind of dynamic tension between current income and capital investment risk is exactly what LPs face, so why shouldn’t GPs face the same trade-off?

It's All About the Benjamins
Of course, the real agenda in congress is not fixing the limited partnership incentive structure, but finding an easy way to raise several billion in additional tax dollars, so I really don’t think the Congressmen care that their proposals are likely to backfire and are logically inconsistent with both capitalism and the fundamental philosophy behind our tax code; they are just trying to make a quick buck by alienating a few as people as possible while wrapping the whole exercise in some media-friendly populist pandering.   Might be good politics, but it’s bad policy.

Private Equity's Software Buying Binge

In 2004 there were, by my count, about 18 acquisitions of public software companies and Private Equity firms made none of them.  By 2006 however, not only had the number of acquisitions risen to 32, but Private Equity firms accounted for 25% of them, up strongly from 11% of deals in 2005 (See table below).

                               

Year	Total Deals	PE Deals	% PE
2004	18	0	0%
2005	27	3	11%
2006	32	8	25%

At this rate I wouldn't be surprised to see private equity account for over 50% of deals in a couple years.

Who Said Maintenance Revenues Aren't Beautiful?
Private equity firms have taken a liking to software firms not because they believe software to be a great growth market but largely because most software firms have what PE firms might call "immature" balance sheets, with little or no debt and relatively high levels of cash.   Rather than targeting fast growing software firms, PE shops typically target "mature" software companies as they not only tend to have lots of cash but they also derive a large percent of their revenues from maintenance revenues.  These revenues are seen by private equity investors and, more importantly their lenders, as a stable source of cash flow that can be used to finance lots of debt.

Seven Steps To Carry
The basic private equity software play book goes something like this:

1. Buy software company
2. Do dividend recap in which you simultaneously lever up the balance sheet and dividend out all the cash you just borrowed plus most of the existing cash on the balance sheet.
3. Raise new fund off of massive IRR created by dividend recap.
4. Do lots of acquisitions to make organic growth impossible to discern
5. Raise prices, slash R&D, increase sales and marketing.
6. Take company public/sell it at same PE you bought it for to investor/large company apparently unfamiliar with the concept of enterprise value.
7. Repeat.

Now I admit this is a bit of snarky characterization of PE software deals because software offers some unique scale effects in SG&A, but I think this characterization is probably closer to the truth than a lot of mumbo jumbo about "value add" "synergies", etc.

And the Winner Is....
For my money,the most notable (and most ironic) private equity buyout of public company in 2006 was the acquisition of SSA Global by Infor. Why?  Because SSA Global was itself a private equity sponsored roll-up of public software companies (including Baan, Ironside, and Epiphany) which was public for all of a year before it was bought by another private equity sponsored roll-up of public companies, Infor, which now rather immodestly claims to be "the fastest growing enterprise software company in the world".

To have the two companies that are following the private equity playbook to a T merge with one another after the first one was only public for a year is just priceless.   I can't wait to see the prospectus for Infor and how they back up their claim to be the fastest growing enterprise software company in the world, it should be a classic.

Launching Inductive Capital ... Finally

Well it's October 1st, the beginning of Q4 2006, and I am happy to announce that I have finally launched Inductive Capital, a investment fund targeting public technology companies.  This may seem like a bit of a departure for many who know me primarily from my days as a VC, but those of you who know me from my days as a Wall Street analyst will probably not be all that surprised.

Before I go any further, I should point out that the reason I haven't blogged since mid-April is that as soon as I took the first serious steps to put this fund in place my lawyers advised me that I should stop blogging in order to avoid any chance of running afoul of a number of investment regulations.  (Incidentally, my lawyers are probably the biggest most respected hedge fund lawyers on the West Coast and believe it or not they did not have a single client that had a blog, so needless to say they were a bit hesitant to let me blog with abandon.)  Since Inductive Capital is a hedge fund, and therefore considered to be perpetually in registration, I still face many legal and regulatory restrictions which unfortunately will keep me from writing about the activities of the fund.  I also need to be especially careful to avoid writing anything that could be construed as fund raising for the fund or trying to provide investment advice, so just so we are clear this post is intended as nothing more than update to everyone who reads my blog on what I am doing now.

I want to be equally clear that I intend to continue this blog from now on and pretty much continue to write about what I have been writing about in the past.  I suspect I my have some commentary on the hedge fund industry from time to time, but given that my new fund will continue to be deeply embedded in the high-tech venture capital space I will continue to write about venture capital and interesting new technology trends.  About the only thing I did in the past that I won't be doing now is publishing lists of stock picks, such as my Virtual Stock Portfolio, or offering any kind of investment advice.

What exactly am I doing?  Well I am running a long/short, low net exposure investment fund, otherwise know as a hedge fund.  The investment thesis behind the fund is something I am particularly passionate about and something that is directly based on my experience as both a VC and a Wall Street analyst.  To put it briefly, the fund has been designed to collect information and insights from the private technology market and then try to apply those insights to help make investments in the public market.   Helping me to collect those insights and information is a formal advisory committee composed mostly of VCs and a few other members of the VC-funded ecosystem.  My advisory committee is composed of a great group of folks, all of whom I deeply respect, and I am also lucky to have a great group of investors many of whom have tremendous experience in both the private and public markets.

I named the fund Inductive Capital primarily to reflect the fact that almost all investment decisions are based on inductive logic and this is especially true of a fund that seeks to apply private market insights to the public markets because you must gain multiple data points from a variety of angles and them filter them based on judgement and experience before you can have any confidence that your reasons for making a particular investment are reasonably sound.

Why did I decide to do a public fund instead of staying in venture? Well it honestly was a tough decision, but I think in the short term there are number of very interesting trends that created a real opportunity for a fund such as Inductive and I was compelled to take advantage of that window of opportunity.   Over the long term I am pretty convinced that the VC world and hedge fund world will increasingly overlap so hopefully my absence from the venture capital world will prove only temporary.

Anyway, enough about me and my new firm.  I look forward in the coming weeks to doing some posts on topics I have covered in the past as well as a few new ones and I hope that everyone who has read this blog in the past will continue the dialoge with me as I really enjoy the interactions.

Dividend Recaps: Currently Questionable, Soon to be Illegal

One of the biggest rages in the private equity world these days is the “dividend recap”.  In a dividend recap, a private equity firm takes over a company with a reasonably healthy balance sheet and then levers it up dramatically, not to invest in the business or support their original purchase price, but simply to generate a ton of excess cash. This excess cash is then quickly paid out as a "dividend" to the private equity firm.  While the tactic is a fantastic way for a private equity firm to improve its IRRs, it’s also highly likely to be illegal or at least financially impractical in the near future.

Private equity firms defend dividend recaps as simply a prudent use of capital and leverage however the truth is that they are really just a blatant tax dodge.  You see dividends in normally run companies come from retained earnings and retained earnings are subject to corporate taxes of roughly 35%-40%.  In addition, up until a few years ago, any taxable entity (such as, say, the GPs in a private equity firm) had to pay ordinary income taxes on those dividends once they received them. Thus, by the time a $1 of corporate pre-tax income made it into the pocket of an investor it was subject to somewhere between 75-80% in taxes.  Not the world’s easiest way to make a buck.

Good Things Come In Threes
Three things changed all of this though.  First, in 2001 Congress cut the tax rate on most corporate dividends to 15% in order to reduce the double taxation of corporate income.  Second, the credit markets dramatically loosened as both short and long term rates plummeted post the 2000 bubble.  Third, private equity firms were able, thanks to robust demand from LPs, to raise huge funds that were more than capable of doing many deals with little or no debt.

With their giant funds and the loose credit markets, private equity firms saw that it was now possible to raise much more cash than they actually needed to buy a given company.   However, rather than downsize their equity funds (and thus their fees and carry) to a more capitally efficient size, the funds instead figured out that they could have their cake and eat it too, i.e. they could invest “too much” equity into deals enabling them to justify their huge funds and then use loose credit to support dividend recaps as a way to restore the “proper” capital structure while magically turning the recently raised debt into profits subject to just 15% net taxes (and a 20% carry!).  One can just imagine all the former investment bankers at private equity firms looking over their spreadsheets and grinning while they whisper “God Bless America!”.

Too Much Of A Good Thing
The problem for private equity firms is that dividend recaps are such a great arbitrage in some respects that everyone and their grandmother is now rushing to do them.  As the size and volume of these recaps increases, the prices of the underlying assets are starting to inflate, making the incremental deals riskier and riskier.  Ultimately, the greater fool will push the edge of the envelope so far that he will set off a spectacular Enron-style collapse and the knives will then come out for everyone.  It is in many ways a classic Wall Street story that has been told again and again and always has the same ending.

Calling All Politicians
However, even before the long hand of market takes its inevitable toll, the government may beat them to the punch.  That’s because dividend recaps are basically exploiting a huge loophole in the tax code and subverting the original intention of the tax cuts.  All it may take is one enterprising politician (Elliot Spitzer anyone?) and one reasonably high profile dividend cap related failure, to bring about a Sarbanes-Oxley style backlash from Washington DC.  It might be a stretch to make dividend recaps illegal, but Congress can surely play with the tax code enough to make them financially impractical.

Until then, private equity firms will undoubtedly “pump up the volume” on dividend recaps in the false hope that their day of political reckoning might never come.   My one piece of advice them is to stand close to the exits and watch what they put in their e-mails.

Long or Short Capital's Web 2.0 Analysis

If you are a financial and technical geek, such as myself, and you enjoy a good dose of humor every once and a while you owe it to yourself to check out Long or Short Capital. They recently published a hilarious analysis of Web 2.0 companies that will make you laugh.  Their Satan's Portfolio post is an absolute classic.

They are also the only website I know of that claims to pay a quarterly cash dividend back to their users (I have asked them to pay mine "in kind" with Cheetos and Redvines) which they do mostly for humorous effect but given all the discussion about Yahoo and Microsoft's research into paying their search customers I wonder if the crew at Long or Short haven't hit on a business model (or perhaps just a cost of doing business) that will inevitably become much more prominent in the blogsphere.

Burnham’s Beat Reports Record Q4 Revenues

Silicon Valley, CA – (BLOGNESS WIRE) – Jan. 11, 2005

Burnham’s Beat today reported record results for its fourth quarter ended December 31, 2005. Revenues for Q4 2005 were $168.64 up 176% compared to $61.08 in Q4 2004 and up 27.3% sequentially vs. Q3 2005. Earnings before expenses, which management believes are the most cynical results we can think of, were also up 176%.

Commenting on the results, Bill Burnham, Chief Blogger of Burnham’s Beat explains “This quarter’s results continue to demonstrate that blogging is a complete waste time. While we did not achieve our previously forecasted results of 100 billion page views and ‘Google-style cash, Baby!’, we remain hopeful that people forgot about those projections. There are several reasons for missing our projections including an outage of our hosting provider in late Q4 which cost us a least $1.00, the continued poor quality of the writing on the site, high oil prices, several deals that slipped to next quarter, and uncertainty created by the war in Iraq. ”

Page views were up 921% in Q4 2005 to 71,772 compared to 7,028 in Q4 2004. However advertising click-through rates declined from 0.78% in Q2 2004 to 0.23% in Q4 2005. In addition, revenue per click fell 56.3% to $0.49/click compared to Q4 2004’s $1.11/click. Commenting on these statistics Burnham added “We continue to believe that page view growth and advertising revenues have been adversely impacted by the switch to “full text” RSS feeds that we implemented in Q3, but we are too lazy to do anything about it. We added an additional search advertising partner in Q4 and were generally disappointed with the results. While revenue per click is higher at this partner, overall click through rates are much lower. In terms of our main advertising ‘partner’ we have seen a clear pattern throughout the year of them reducing the revenue share they pay to their blog-related ‘partners’. Apparently they aren’t making enough money as it is and need to stick it to the little man.”

Revenue per post was $9.92 in Q4 2005 compared to $6.11 in Q4 2004. “Revenue per post indicates that we could pretty much write about paint drying and search engines would still drive enough random traffic to our site to make a few bucks.”

Affiliate fee revenues were $33.91 in Q4 2005 up 963% vs. $3.19 in Q3 2005. Burnham notes “We launched our affiliate fee division in Q1 of 2005. This unit performed poorly until we decided in early Q4 to blatantly pander to affiliate revenues by using sensationalized rhetoric and better placement, a tactic which appears to have worked well.”

Pro-forma expenses were $44.85 up 67% in Q4 2005 vs. Q4 2004 primarily due to switching from the basic $8.95 hosting package on Typepad.com to a $14.95 “advanced user” package which management has yet to really figure out how to use but it would be embarrassing to tell a fellow blogger that they were still using the “basic” package as only newbies do that.

Readers are reminded that Burnham’s Beat’s financial results exclude all labor, connectivity, and capital expenses, all opportunity costs of actually doing something useful, and the considerable goodwill charges that result from constantly antagonizing people by badmouthing their company/industry/personal views. Including these expenses Burnham’s beat would have reported earnings of approximately -$1,000,000,000 but management does not believe that these actual results fairly reflect the alternate reality in which we currently exist.

FORWARD OUTLOOK

Burnham’s Beat is comfortable with its previous guidance of 100 billion page views and ‘Google-Style cash in 20056, Baby!” and hopes that people remain forgetful.

 
Burnham’s Beat and Subsidiaries
Pro-Forma, Pro-Forma Preliminary Restated Unaudited Results

                                                                                                                       

	Q4 2005	Q4 2004
Revenues
Advertising	$134.73	$61.08
Affiliate Fees	$33.91	$0.00
Total Revs	$168.64	$61.08
Expenses
Hosting	$44.85	$26.85
Operating Inc	$123.79	$34.23
Taxes	$43.32	$11.98
Net Income	$80.47	$22.25
Metrics
Page Views	71,772	7,028
Posts	17	10
Ad impress	120,513	7,028
Click-thurs	278	55
Revs/PV	$0.00	$0.01
Revs/Click	$0.49	$1.11
Rev/Post	$9.92	$6.11

P.S. Yes these are the actual numbers.

Virtual Stock Portfolio Update: July

In July my virtual stock portfolio was up only 1.1% compared to the NASDAQ's blistering 6.2% gain thanks to fact that I got clobbered on a couple of short positions.  On average my stocks were off almost 6% thanks to two smaller short positions, Convera and Wave Systems, that had inexplicably huge months.  Both stocks have cult followings and the cults appear to have won this month.  My longs all did well this month though, so I was able to avoid a net loss.  I guess that's what is supposed to happen in a long/short portfolio but it is still not fun to under perform.

Overall, my portfolio is up 21.6% YTD vs. 0.4% for the NASDAQ, so I am still nicely ahead of the market, but I am overdue for a bit of portfolio re-engineering so I am going to make a few changes this month.  First I am going to cover two of my poor performing shorts, Salesforce.com and Convera, because they both look like the momentum guys have gotten a hold of them.  Second, I am going to reduce my exposure to one of my longs, Neteller, and add a new long that is related to Neteller, FireOne, but trades at a significantly lower multiple.  I am also adding Kana as a short, as I see it following a path similar to what Broadvision did (i.e. going private at a big discount to its current price).  With these changes, I am somewhat net long on a cost basis, so I will try to look for a decent short this month to get the portfolio back into balance by September.

Long Picks

Company: SPSS Ticker: SPSS
Sub-sector: Business Intelligence
Investment Thesis: SPSS is a player in the business intelligence space with a particular emphasis on predictive analytics, something that is particularly hot right now. The stock has been battered by a restructuring that the company went through last year as well as an accounting restatement. My thesis is that the new product set is strong and the accounting trouble is overblown.
Performance: Since 4/30/04: +38.1%  Jul vs. Jun: +2.2%
Comments: The stock has been somewhat quiet recently but has been slowly trading upward so I will keep my exposure for the time being as the BI space remains hot and the multiple laggards in the space (such as SPSS and MSTR) are slowly closing the gap the the premium plays (BOBJ and COGN).

Company: Stellent Ticker: STEL
Sub-sector: Content Management
Investment Thesis: Stellent is a relatively sleepy, but well established, content management company that is attractively priced.  I like the content management space as a consolidation play.
Performance: Since 6/30/04: -1.1%  Jul vs. Jun: +12.7%
Comments: Strong month that made up a lot of lost ground, but this stock has been somewhat of a disappointment as it appears to range trade with no real direction.  Probably worth swapping out with something more attractive at some point in the near future.

Company: Neteller Plc. Ticker: NLR.L
Sub-sector: Financial Services
Investment Thesis: Every portfolio needs a flier and this sure counts as one. Neteller is Europe/Canada’s answer to PayPal and it has been making a killing by servicing markets, particularly on-line gambling, that PayPal has been pressured into exiting by the US Justice Department.  I know, I know, this is not a software stock, but I still follow on-line financial services quite closely and I feel compelled to point out this stock because it is such an attractive buy.
Performance: Since 6/30/04: +409%  Jul vs. Jun: +27.2%
Comments: The energizer bunny of stocks, it keeps going and going and going up.  Still only trading at a mid-20s PE despite the huge run-up.  It has gone up so much that it represented a disproportionate portion of my portfolio, so this month I trimmed my position back to be much more in line with the other positions.  I also added another stock, FireOne, that is basically in the exact same business, but trades at 14X earnings, so I still am overweight in terms of portfolio exposure to Internet payment processing for gambling companies.

Company: Sportingbet Plc. Ticker: SBT.L
Sub-sector: Internet Gambling
Investment Thesis: Sportingbet is the largest on-line gambling operator in the world. At 23-25X 2005 EPS this stock is still attractive relative to its growth rate (25-30%) and especially attractive relative to other Internet commerce plays. I don’t like the big options overhang in this stock or the poor margins (due to sports betting business) but this is a chance to own a major player in an important on-line commerce player at an attractive valuation.
Performance: Since 11/30/04: +120.5%,  Jul vs. Jun: +11.3% 
Comments: This has been a pretty easy play on Internet gambling and I don't see any reason to get out yet despite the good gains to date, although the stock may suffer as more Internet gambling companies get listed in the UK (for example Party Poker's (PRTY.L) recent listing).

Company: Microstrategy Ticker: MSTR
Sub-sector: Business Intelligence
Investment Thesis: I like the BI space in general and have been keeping my eye on Microstrategy.  This has recently been one of the cheaper stocks in the space, yet it also has one of the better product portfolios and market positions.  From what I hear, businesses are still spending big bucks on BI and MSTR should be a big beneficiary.
Performance: Since 3/31/05: +42.2%,  Jul vs. Jun: +45.5%
Comments: MSTR had a huge month in July thanks to a strong earnings report combined with a big repurchase announcement.   The repurchase should give the stock a bit of a floor in the next few months, so I will hold on to it, but I think all the easy money is now off the table as it is trading much closer to the other plays in the space now.

Company: FireOne Group Ticker: FPA.L
Sub-sector: Financial Services
Investment Thesis: FireOne operates an Internet payment service very similar to Neteller.  It is used primarily by on-line gamblers to transfer money around.  I added FireOne to the portfolio because I wanted to maintain overweight exposure to the these kind of Internet payments plays without putting all my eggs in one basket (Neteller).  It helps that FirePay trades at 14X earnings compared to Neteller's 24X, but FireOne is admittedly not as big or well run as Neteller.  I seriously considered adding, Optimal (OPMR), the parent of FireOne and an 80% owner, instead of FireOne, but the relative valuations suggested it was better just to go with pure exposure to FireOne.
Performance: Since 7/31/05: NA,  Jul vs. Jun: NA
Comments: Hopefully FireOne will be able to close at least part of the considerable multiple gap between itself and Neteller.  Given the lagged nature of its results vs. Optimal it may be possible to make very good guesses at its performance well in advance of a public announcement, so I should be able to get a bit of a "head's up" on any particularly good or bad news.

Short Picks
Company: Autonomy Ticker: AUTN
Sub-sector: Content Management
Investment Thesis: Autonomy is a UK-based purveyor of advanced enterprise search software a space I know well from some of my VC investments. The enterprise search space is crowded and getting even more competitive with the entry of folks like Google. Autonomy’s secret sauce, its categorization software, is increasingly being duplicated by it competitors. Autonomy continues to trade at a premium to the market. This premium appears to be largely an artifact of the fact that autonomy is a bit of a cult stock in its home country of the United Kingdom.
Performance: Since 1/26/04: +17.2%  Jul vs. Jun: -7.3%
Comments: Ever since AUTN delisted from the NASDAQ and relisted with the LSE, it has been a much quieter stock and has traded up a bit as well.  I think a lot of this has to do with the much lower reporting requirements of the LSE, but it's hard to tell.

Company: Salesforce.com Ticker: CRM
Sub-sector: Vertical Applications
Investment Thesis: Salesforce.com is a, mostly, hosted sales force management application. It's a good product, most of my start-up companies use it, but it is expensive the longer you use it and the larger your company gets. CRM is 2nd most highly valued stock in the software space despite the fact that it is facing increased competition from the big boys of enterprise software and that it’s very hard to rapidly grow subscription-based revenues. Any misstep and this stock will down 25% in a heartbeat.
Performance: Since 1/26/04: -81.0% Mar vs. Feb: -15.0%
Comments: I got killed on this short and can't take it any more so I am covering this month.  The company continues to have a crazy valuation (9X EV/Sales), but the management team is doing a good job telling the growth story and is also keeping revenues growing faster than I thought they would.  As the poster-child of software as a service the stock gets a lot of trend money as well.  I am not going to fight the trend anymore.

Company: Wave Systems Ticker: WAVX
Sub-sector: Security
Investment Thesis: I first encountered Wave when I wrote my initial analyst report on Wall Street in the mid-1990s. Wave has remained in business largely by claiming that it is developing revolutionary security technologies, kind of like a bio-tech company that never gets out of trials. With a grand total of $1.4M in revenues over the last 3.5 years, a $4M/quarter cash burn rate and only $4M or so in the bank, a day of reckoning is fast approaching.
Performance: Since 10/1/04: -28.6%  Jul vs. Jun -50.0%
Comments: In July Wave was running out of cash and probably has two months cash left at most right now, yet the stock was up 50%.  This means one of two things either A) they are in talks to sell the business at a premium or B) someone is manipulating the stock.  Given the history of the stock, I think that B is much more likely as the stock has mysteriously run up in advance of two prior PIPES (giving the buyers the opportunity to short their positions in advance), however it will take a month or two to know for sure.  I am still hanging on to this short despite last month's blood bath because its clear that the company is approaching the end of its rope.

Company: Convera Ticker: CNVR
Sub-sector: Content Management
Investment Thesis: I ran into Convera when I was on the board of Stratify.  I was unimpressed with Convera’s business then and I am unimpressed with it now.  They have a decent market niche in the government sector but have never been able to really expand out from there and face increasing competition from the likes of Google, Verity, and Microsoft.  The stock is up strongly in the past few months thanks to the company’s announcement that they are going to enter into the web search market. This hype has disguised very poor license sales of the core product and a continued high burn rate (averaging about $4M-5M a quarter). Eventually the chickens will come home to roost here...
Performance: Since 11/30/04: -79.6%  Jul vs. Jun: -85.6%
Comments: The stock went on a huge run this month thanks to a PIPE from Legg Mason and lots of speculative interest in Convera's upcoming Internet search initiative which won't even start selling until Q4.  I  clearly underestimated how much people were willing to pay for hope and given that they won't get any real sense of how the new product is doing until Q4 now, it makes sense to cover and cut my near term losses.  I will be back to short this in Q4 though as the company is trading at 15X EV/Sales which is just silly given that there's no proven demand for their new product and it's not like the existing Internet search guys are going to roll-over.

Company: Manugistics Ticker: MANU
Sub-sector: Supply Chain
Investment Thesis: Manugistics is in a tough spot strategically and financially. Strategically it's facing increased competition from the big ERP players who are successfully bundling more and more supply chain functions into their core offerings.  Financially, Manugistics has a crushing debt load and a negative tangible book of $55M.  It's going to be very hard to pull this company out of the tailspin.  The debt holders may ultimately convert to equity and save the day, but things will have to get a bit worse on the equity front before they are willing to talk turkey.
Performance: Since 2/28/05: +4.0 Jul vs. Jun: -8.4
Comments: Still range trading a bit.  I still think that the equity is going to get pimped by the debt at some point before the end of the year, so it's worth waiting around for that day of reckoning.

Company: Kana Software Ticker: KANA
Sub-sector: CRM
Investment Thesis: Kana has been in a long decline ever since the bubble burst.  Once a CRM darling, it is now generating only about $2M in license sales/quarter and $10M in total revenues.  It continues to lose millions a quarter despite having only ~$10M in cash.  In addition, the CEO recently left in the wake of getting censored for expense account abuses and the company hasn't filed a 10K or 10Q because they have new auditors that are taking much longer than expected.  The new CEO is going to have to undertake a major restructuring to get this place profitable.  This company may ultimately experience the same fate as Broadvision in that it goes private at a big discount.
Performance: Since 7/31/05: NA Jul vs. Jun: NA
Comments: They need to file a 10K by the end of the end of the month.  I can't imagine that the 10K will have lots of good news in it.

An Appeal for Reason: Why Frank Quattrone’s Appeal Should Be Granted

As some may know, I used to work as a Wall Street technology analyst for CSFB and DMG.   My ultimate boss was a guy named Frank Quattrone.   Frank was basically the best technology investment banker on the planet.  Being the best, he made a lot of money.   Unfortunately, the money in turn made him a convenient symbol of “Internet excess”.  Thus, when the Internet bubble burst in 2000 and the French Revolutionary-style purge began, the knives came out for Frank with a vengeance.

Let Them Eat Frank
In an effort to throw some red meat at aggrieved individual investors (and get some piously sanctimonious face time with the press), the federal government and the SEC decided to tag-team Quattrone and launched a number of coordinated investigations in an effort to try and pin some criminal blame for the bubble’s collapse on Frank’s well paid shoulders.  Unfortunately for the government, despite all of their efforts, they basically came up with bupkis as their criminal investigations drew a blank.

That was until some enterprising paralegal unearthed a single 22 word e-mail in which Frank briefly endorsed another colleague’s much longer e-mail encouraging employees to follow the firm’s “document retention policy” and throw away any old documents that weren’t required.  Stymied in its attempts to pin any kind of criminal wrap on Quattrone, the government now found a convenient scapegoat for their fruitless efforts:  they would accuse Frank of obstructing justice by nefariously encouraging employees to destroy documents.

As I outlined a while back, the government’s case requires a jury to simultaneously buy two mutually exclusive and logically inconsistent points of view.  The first view they must buy is that Frank was a master of the universe, so smart, so canny, and so capable that it would be impossible for him to have not known that his e-mail was illegal.  The second view is that Frank is so skittish, clumsy, lazy and ignorant, that he would make the centerpiece, indeed the sole piece, of his obstruction of justice efforts, a very public and entirely superfluous e-mail to 500+ people.  It’s as if Frank Quattrone, master of Wall Street, suddenly hadn’t even graduated from the kindergarten school of Corporate Intrigue and Politics.

If At First You Don’t Convict, Try, Try and Try Again
Undeterred by the logical contradictions of their case, the government plowed ahead and put Frank on trial.  The first trial ended in a hung jury, but the government decided to try again.  The second time proved the charm for the government and Frank was convicted on all three counts of obstruction.  The judge in both trials, who made little secret of his dislike for Frank and is a great exhibit for why mandatory retirement ages for Federal judges should be enacted, not only gave him the maximum sentence for the three counts, but gratuitously tacked on some extra time because the judge personally believed that Frank lied when he was on the stand (even though he wasn’t charged with perjury and the jury never considered that charge).

Appealing For A Reason
The reason I am rehashing all of this is that tomorrow Frank’s lawyers are presenting to the Federal Appeals Court in New York in an attempt to get his conviction overturned.  Having followed the case closely I have had an opportunity to read Frank’s appeal as well as a bunch of other documents (you can read the latest doc here ) and I have come to conclusion that if there is any justice in the world Frank will, at the very least, get a new trial, and if he’s lucky he will either have the case either thrown out completely or sent back with so many restrictions that the government will have to finally give up the ghost.

Now I am no lawyer and I am definitely not a Federal Appeals Court judge, so my opinion basically counts for nothing in the grand scheme of things, but I can read and I can reason, and given this it’s hard to see how Frank won’t at least get a new trial given the following points:

1. Arthur Andersen To The Rescue: Frank’s best chance for an acquittal has to do with a recent Supreme Court case involving Authur Andersen, the once mighty accounting firm.  As you may recall, the government charged Andersen, as a firm, with obstruction of justice based on a set of circumstances very similar to Frank’s.  In Andersen’s case, with Enron rapidly imploding and the specter of regulatory action increasing hourly, an internal Andersen lawyer sent an e-mail out to members of its Enron account team encouraging them to follow the firm’s “document retention policy”, which basically was legalese for “my god man, destroy every document you can before the feds show up”.   The government maintained this order to destroy documents represented a criminal conspiracy to obstruct justice and charged the entire firm with obstruction of justice, which for a corporation basically amounted to a summary execution without trial.   A few weeks ago, the Supreme Court ruled that the government actually had no right to charge Andersen with obstruction of justice because the court held that you can’t convict people for following a corporate policy when they have no evidence to suggest that they shouldn’t.  While it was hollow victory for Andersen (it went out of business a long time ago) it was a potentially huge victory for Quattrone.  In Frank’s case, he too was simply encouraging employees to follow a valid policy (in fact the government didn’t even charge the guy who authored the main e-mail encouraging people to follow the policy).  While the government maintains that Frank should have known that the documents in question were under government subpoena or shortly would be, they also admit that they have no evidence anyone ever told him that.  So in many respects Frank’s position is very similar to Andersen’s and one would expect that the appeals court judges, with the Supreme Court decision hot off the presses, would also see the same similarities.
2. There’s This Little Bit of Evidence We Forgot To Tell You About…:  Turns out the judge excluded so much evidence in Quattrone’s trial you’d think he was a North Korean censor editing a Heritage Foundation report on Kim Il Jong.   For example, the judge wouldn’t let Quattrone’s lawyers enter into evidence discussions amongst CSFB’s own lawyers in which they, in violation of their own policies, decided not to tell anyone in the firm about the government’s document subpoenas, the same subpoenas Frank was supposed to have obstructed.  How he is supposed to have obstructed a subpoena that his firm’s own lawyers apparently didn’t even tell him about is beyond me and probably would have been beyond a jury, but they never got to hear about that.  Another choice nugget the judge decided to exclude were a huge set of e-mails in which Frank basically endorsed other colleague’s e-mails.  The defense obviously wanted to show the jury that it was routine for Frank to offer short endorsements of other people’s e-mails so they could demonstrate that the e-mail about the document retention policy was not unusual in the slightest, but the judge inexplicably excluded the e-mails as irrelevant.
3. Following the Wrong Instructions:  At the end of trials, judges give juries instructions in which they basically tell the jury how they are supposed to apply the law.  In Frank’s case, the judge’s instructions basically said “you can convict this guy even if you think he just had a hunch that he might be breaking the law and you can even convict if him if you think he played stupid and consciously avoided trying to find out that he might be breaking the law.”  These instructions were similar to ones in Andersen’s case that the Supreme Court said were silly so there’s a decent chance that the appeals court will follow suit.

There are a lot of other little things that bolster Frank’s appeal, but if the appeals court finds in Frank’s favor on any of these main issues outlined above, it will probably get him a new trial at a minimum and may just get him completely acquitted as the government knows it will face a much tougher fight a third time around with the precedent now set by the Andersen case.

In fact, if Frank does get acquitted the stage will be set for a Phoenix-like comeback as it looks like he also has a decent shot of overturning the SEC’s lifetime ban in another appeal.  If he were to beat both the Feds and the SEC, there would be nothing preventing Frank from coming back to Wall Street and putting "the hurt" back on all the competitors that merrily jumped up and down on his supposed grave.  Unfortunately, I suspect that will never happen as Wall Street probably doesn’t hold the same allure these days and Frank’s experience with the “justice” system has likely left him with more important battles to fight.   It’s too bad though as that sure would be a sight to behold.

North Korea Comes To Wall Street

Try to imagine this:  Your e-mail and phone calls are constantly monitored by a group of people who can at any time block your communications for any reason they see fit.  Everything you write is closely reviewed and liberally edited by people whose sole job is to make sure that you are in strict compliance with government policies.  You can not speak to many outsiders, especially members of the press, without having an official “minder” present.  You can not even speak to many of your own co-workers without first getting official permission and even when you get that permission you must still have an official “minder” present to oversee the conversation.  Worse yet, if you do speak or write publicly, the government reserves the right closely parse whatever you say and charge with your serious crimes if they believe your speech has even slightly deviated from the government declared orthodoxy.

No, you are not a North Korean diplomat or Cuban baseball player, you are a Wall Street analyst.  That’s right, in the name of “protecting” investors, the government, in conjunction with the major investment banks, has conspired to create an Orwellian regulatory “regime” on Wall Street that Kim Jong-Il himself would be proud of.   While the regime differs somewhat by firms, today most Wall Street analysts have all of their communications monitored and often have e-mails, both inbound and outbound, “bounced” without explanation by their compliance departments.  Analysts must get official approval just to talk to their colleagues in their investment banking department and face severe reprimands for having even a simple “Hi, How are you?” conversation with a banker in the elevator lobby.  Even if they do get permission to meet with one of their investment banking colleagues, a member of the compliance department must mediate and oversee the meeting in order to insure that no inappropriate speech is uttered.   Some firms have gone so far as to require analysts to have “minders” present when they speak to the press or even when they visit a private company. One has to wonder: how has a country that prizes the freedom of speech and association as two of its most essential freedoms let those freedoms become so blatantly infringed upon?

The government justifies such infringements on the basis of “protecting” investors from potential conflicts of interest between the research and corporate finance arms of an investment bank.  The basic gist is that unscrupulous research analysts may only say positive things about a bank’s corporate finance clients because they stand to get a cut of the investment banking fees.  Such “false” advice constitutes fraud and therefore opens the door for the government to step in and regulate things.

But this logic has a very, very slippery slope.  If the government is trying to eliminate conflicts of interests in commercial relationships why are they stopping with investment banks?  There are obviously lots of other commercial relationships where consumers are “advised” by parties that have clear conflicts of interest such as:

1. Realtors:  For many, if not most Americans the biggest investment decision they will make is not some Wall Street stock, but buying their home.   In conjunction with this transaction, most people must deal with realtors.  Realtors clearly do not have compliance departments looking over their writings or else classified listings such as “cozy, vintage, bungalow near mass transit” would read “small old shack next to railroad tracks”.  In addition, realtors can have huge conflicts of interest.  Not only do most realtors simultaneously represent both buy side and sell side clients, but if an agent works at Realtor XYZ they often have a vested incentive to show their clients mostly properties from Realtor XYZ and refer clients to their in-house mortgage banker.  Given this, as anyone who has ever shopped for a house will tell you, you should always be careful when dealing with a realtor because you never know when they are only looking out for their own interests.  That’s why word of mouth and reputation are so important in the realty business.  Sure, just like investment banks, realtors must deal with a fair amount of regulation and disclosure, but unlike investment banks realtors are not subject to draconian restrictions on what they write or who they can associate with.
2. Car Salesmen:  Perhaps the second biggest financial decision that most people make after buying a house is what car to buy.  Car salesmen are of course notorious for being less than honest about the cars they are selling and for having lots of conflicts of interests such as dealer-rebates, in-house financing, etc.    However you don’t see the government threatening to throw them in jail every time they lie and say “this model is selling like hotcakes, but I might be able to reserve one for you if you can act today” when they know that their manager told them that morning “get this dog off the lot before the end of the month and I’ll pay you a special bonus.”
3. Waiters:  Many diners often ask waiters “What’s good on the menu?”  This question presents a classic conflict of interest.  Waiters (in the US) receive most of their compensation in tips and thus have a strong incentive to recommend the most expensive item on the menu.  In fact, some restaurant managers are known to instruct waiters to recommend to diners the most expensive meals on the menu.  Applying the government’s security industry rationale to restaurants, any waiter that recommended the filet mignon when they actually felt that the cheaper pasta special was a better dish would be throw in jail.  Of course most consumers know that if a waiter immediately recommends the most expensive item on the menu, they probably don’t have the diner’s best interests at heart.

The point is that almost every commercial relationship in the world is subject to some potential conflicts of interest and the average sentient consumer is already well aware of this.  If consumers feel like they are being taken advantage of, they take their business elsewhere and the reputations of those service providers ultimately suffer.  Those service providers that are known to provide good service despite the inherent conflicts build good reputations which ultimately translate into brands which help build long term franchise value.  Wall Street analysts are no different.  Analysts who screw their clients by advocating bad deals get bad reputations.  Analysts that get a reputation for putting the interests of their clients first, even at the expense of their firm’s financial interests, ultimately have the best reputations.

The only difference with Wall Street analysts is that the government somehow feels that because their commercial relationship involves stocks and not houses or cars, that they have the right to intervene and impose draconian restrictions on freedom of speech and freedom of association.  Given that in the wake of the Internet bubble everyone pretty much hates Wall Street and Wall Street analysts in particular it’s easy to see how the government has gotten away with this (and the mainstream media, supposed defenders of free speech, have acquiesced to this) but it’s also important to contemplate the very slippery and inconsistent slope we are now on in terms of some of our most fundamental freedoms.

As some of you know, I was at one time a Wall Street analyst, so that is why this subject is near and dear to my heart.  This should not be read an attempt to rationalize or legitimize investment banking conflicts of interest.  I actually am a big supporter of full, clear and prominent disclosure of any potential conflicts and I think that government regulation is this regard is actually a good thing.  However I am opposed to the government either directly or indirectly imposing restrictions on our basic freedoms, especially when it’s crystal clear that the free market ultimately does a much better job punishing those who abuse conflicts of interest and rewarding those who don’t.  The government’s current posture towards Wall Street research represents one of the worst and most mis-guided examples of how the “nanny�