The Death of a Modest Man of Greatness

My friend Frank Samuel died yesterday in a one-car accident not far from his home in Geauga County. He was driving alone, wearing his seatbelt, in the middle of the day on a familiar road. His car slipped on a turn, spun clockwise, rammed into a guardrail, and his life was extinguished. The police have said that alcohol was not a factor, but anybody who knew Frank would have known that anyway. I occasionally saw him sip a single glass of white wine, but never more.

Frank was my first friend when I moved from Silicon Valley to Cleveland. I was introduced to him by Bill New, inventor of the pulse oximeter and founder of the great medical technology companies Nellcor and Natus. Bill had known Frank from his days leading the Health Industry Manufacturer’s Association, HIMA, in Washington. When I met Frank in 1997 he had returned to his home state of Ohio to lead the Edison Biotechnology Center, a statewide organization tasked with creating life sciences entrepreneurship in Ohio. It was also mentioned by somebody that Frank had returned to Ohio to dutifully take care of an aging mother, though it wasn’t something he talked about. He wouldn’t have.

It was during his tenure at the Edison Biotechnology Center that Frank hired me as a consultant. I was between jobs and needed work and Frank found a project for me. That was the kind of man he was. Frank hired me to conduct a study of how to make Cleveland an entrepreneurial metropolis—again, he repeatedly pointed out. In the early part of the 20th Century, Frank would say, Cleveland was the hub of entrepreneurship in the U.S. Of the 50 millionaires in the country in the 1920’s, 30 hailed from Cleveland, he would point out. Cleveland produced such luminaries as John D. Rockefeller, Jephtha Wade, and John Severance. Their legacy included Millionaire’s Row along Euclid and Prospect Avenues (remnants of which still remain), cultural institutions like the magnificent Cleveland Symphony Orchestra, leading foundations such as the Cleveland Foundation, and Lakeview Cemetery, where Rockefeller is buried beneath a tall obelisk and the Wade Chapel memorializes the leader of Western Union with scenes from the Old and New Testaments composed by Tiffany of thousands of pieces of glass.

Frank’s spirit of joy and wonder permeated his tenure at EBTC, as it was known, and he did a lot to advance the cause of regional entrepreneurship. The study he paid me to conduct had its run, along with other studies, but it did lead to an introduction to Jamie Ireland, who through his leadership at the Generation Foundation had financed the study. Jamie was instrumental in coaxing Cleveland’s many foundations to remember the source of their endowments and to reinvest some of their capital back into the regional economy. Jamie and Jim Petras and I decided that a study was fine, but taking action was better. We formed Early Stage Partners, an early stage venture capital fund, to invest in Cleveland’s start-up companies. Frank was instrumental in getting us going, administering a grant application to the Governor’s Technology Action Fund that was the formation capital for Early Stage Partners.

Frank’s influence expanded further when, during the Governorship of Robert Taft, he was appointed as Science and Technology Advisor to the governor, a position which he held from 2000 to 2007. Among his accomplishments were marshalling the Third Frontier through the legislature. This was a voter-approved bond measure that raised billions to invest in technology development in Ohio. Whenever I traveled to other states, I was always asked about this program—what it was, how Ohio had done it, how it was managed, how they could do it in their state. I always told people to call Frank. Frank was also instrumental in creating an environment of support for the Ohio Capital Fund, a fund-of-funds that was instrumental in bolstering Ohio’s Venture Capital community.

When the Taft Administration was termed out, Frank returned to Geauga County, where he again formed an organization focused on community revitalization through entrepreneurship—the Geauga Growth Partnership. I didn’t see him much during this time, but starting about two years ago, I sought him out to gather his ideas about how to further bolster Ohio’s entrepreneurial and venture capital industries. Support for these initiatives had fluctuated in Columbus, and some of the signature accomplishments of the preceding decade seemed to be in danger. As usual, he was fully informed, thoughtful, incisive in his opinions, and action-oriented. I asked him if he thought that Ohio would support a statewide venture organization and he was qualified in his response. The state needed such an organization, of this he had no doubt, but he wasn’t sure that the disparate parts of the state could be brought together behind one organization, or that there would be sufficient financial support.

A group of trustees on the board of the Ohio Venture Association persevered with the idea, however. We determined to conduct a venture fair and use the profits to finance Frank as Executive Director of a newly formed statewide venture organization. We thought he would be perfectly suited to the role, and he was, it turned out. The Great Lakes Venture Fair was held in October of 2012, just two years ago, and the profits were sufficient to engage Frank as a consultant on the project.

Frank was at first skeptical of support for a statewide venture organization. He traveled the state talking to people and asking for indications of financial interest. He conducted surveys. He concluded that the organization could expect a modest budget sufficient to support a part-time executive director and a consultant on policy affairs. And then Frank traveled around Ohio asking for funding commitments, formed a board of directors, delegated an exercise to develop a mission statement, and engaged with constituents around the state to increase support for Ohio venture capital and entrepreneurship.

Within six months, Venture Ohio, as the new organization was named, had more members and far more financial contributions than anybody had thought possible. I attribute this to Frank’s skill at both creating a vision and operating at the tactical level to bring people of many interests and perspectives together behind shared goals. The culmination of Frank’s success in creating VentureOhio was on evidence just over a month ago, at the organization’s first annual dinner at the Blackwell Inn and Conference Center on the campus of Ohio State University. The room was packed—far more attendees than had been anticipated. Networking occurred; awards were given; food was consumed, and the state’s venture and entrepreneurial communities had a chance to look at themselves and say “Wow, we’re bigger and more significant than we thought we were.”

In my last exchange with Frank, I sent him an e-mail congratulating him on the success of the VentureOhio dinner. He responded, as he always did, by trying to give me some of the credit. That’s who he was.

Nobody thought at the time that this event would be the capstone to Frank’s career, but if it had to be, it was a fitting one. Frank was a modest man, self-effacing and eager to give credit to others. But the hundreds of people in the room at the Blackwell Inn were a testament to his skill. He was a singular force in Ohio’s transformation from a Rust Belt economy to an entrepreneurial one, and he will be missed. I will miss him, my friend, Frank Samuel. I do not know how you replace a person like Frank.

At Quicken, Culture is Everything

I had the opportunity last week to tour a dozen or so of the more than 40 buildings in downtown Detroit that Dan Gilbert and his various associates and companies have bought and refurbished. It was an amazing experience. Building after building, interconnected by walkways and underground passages, has been repurposed into really cool workspace for young tech workers (with a few of us seasoned types sprinkled in for good measure). Nobody in Silicon Valley has it better.

I was attending Detroit Venture Partners’ annual Demo Day with more than a hundred other people, including many out-of-town VCs, most of whom were originally from Michigan but had to leave after school to find suitable jobs. There is a subtle—perhaps not-so-subtle—attempt to recruit these talented people back to Michigan to help rebuild the economy.

Such a tour is one of the standard components of any visit to this special kingdom. It’s usually led by Bruce Schwartz, the fedora-wearing tour guide who describes himself as a devoted advocate of Detroit; a childhood friend of Dan Gilbert; and the former CEO of a company in the mortgage business. Recent visitors, he reports, have included Madonna; Michael Bolton, who is directing a documentary on Detroit’s rebirth; and Warren Buffett.

The tour has a few interesting touch points: on the eighth floor of the former headquarters of Chase Bank—their logo is still on the outside—is the main cafeteria for employees of Quicken Loans and the many associated Dan Gilbert companies. It is as good as any Silicon Valley food court, and I have toured those at Google, Apple, and Pixar. Chase still has some operations in the building; you can tell which floors they occupy by their corporate dullness and lack of entrepreneurial energy.

Similarly, the building in which Dan Gilbert keeps his office, and the model of downtown that shows all the buildings that are being repurposed, is the headquarters for the venerable last-generation software company Compuware. Riding up the open glass elevators you can see where Compuware ends and Quicken begins. Bruce points it out. One is dull, grey, colorless and lifeless; the other is vibrant, colorful, energetic, and buzzing with activity.

“Culture is everything,” Bruce says, quoting a few of his favorite corporate sayings. They call them “isms.” Various of these are painted on walls throughout the tour, and passing employees, when asked, can cite a favorite one. This is one way that people are selected in, and out, of the interrelated companies.
Three of the locations stand out most in my mind. One is the security center of the 20 or so square blocks of downtown Detroit. In it are dozens of monitors that link to cameras dotting downtown. “You can’t take pictures here,” Bruce warns.

In this basement command center, personnel can monitor pretty much anything that goes on in the area. For our benefit, security personnel bring up a picture of a hoodlum who grabbed an iPad out of a tech worker’s hands one day in Campus Martius, the center of the zone. A picture of him was taken off a camera and, when he returned the next day to the same park wearing the same shirt, he was arrested. (Whoever said criminals were smart?) The message spread to this dumb crook’s associates, says Bruce, is that this is not an area to do crime.

A second location is the basement of the old First National Bank building. Vaults no longer needed in the age of digital currency are left open and surrounded by tech worker space—couches, open cubicles, art work. When the building was bought, it didn’t come with keys to the many safe deposit boxes in the vault, most of which remain unopened. “We didn’t want to deface it by breaking them open,” Bruce says. Warren Buffett, fittingly, was the only person to ever open a safe deposit box on a tour and find something—a dollar. “It figures,” says one person on the tour. The vault is furnished with chandeliers and a long table, and can be rented for dinners.

The third location that stands out in memory is the fulfillment area for Quicken Loans. It’s in a basement somewhere—I got dizzyingly lost after a while, but it might have been beneath the old Federal Reserve Building on West Fort Street. Bruce showed us the loan documents that a Quicken customer gets: neat, tidy, clear instructions, all in a cardboard mailer the size and shape of a portfolio case; everything in its place.

“We reimagined the mortgage fulfillment process,” Bruce says. Who takes the time to reimagine the package of papers a homebuyer gets on closing a mortgage? Someone who believes in this: “Obsessed with finding a better way,” which is one of the aphorisms Bruce quotes to us.

I have bought a few houses in my life, and the process is horrible. The documents are mind-numbingly opaque; the person explaining them is motivated by a commission, not by serving me; the documents get filed away and never seen again. Lawyers wrote them and were, apparently, paid by the word. Not so here; the documents are clearly labeled, concise, and simple to understand.

It’s good business to do mortgages this way, too. In the wrap-up to the recent mortgage crisis, mortgage originators and banks paid billions of dollars in fines and were prevented by courts from foreclosing on houses due to poor documentation.

The fulfillment area is staffed by young workers, with a seasoned manager or two. They’re used to tours and they greet us warmly. They seem genuinely happy, too, which is hard to imagine for somebody who basically works in a mailroom in a basement. How could this be?

As Bruce says, “culture is everything.”

Detroit Comes Alive–and Still Has A Way To Go

I spent last Thursday and Friday at TechWeek Detroit, which coincided with the first extended nice weather of the spring. It was a great event, bringing energy and vitality to a downtrodden city that is experiencing a rebirth. Detroit is on the way back, and in a big way. The scale of what is happening surprised me. Here are some impressions:

  • I stayed at the recently renovated Pontchartrain Hotel on the Detroit River, parked my car, and walked the city. You can’t really experience the life of a metropolis except on foot.
  • The hotel renovation was a success (with one exception): the lobby, restaurant, and rooms are modern and appealing; my room was large, well laid out and attractively furnished, with nice views in two directions of the river and Windsor, Ontario. The sound-proofing was a failure, though; a car waiting for one of the staff to get off shift, pounding hip-hop twelve stories below my room, disturbed my afternoon nap. This was a regular feature of my stay, pretty much around the clock.
  • The juxtaposition between what is good and new about Detroit, and what remains to be fixed, was a theme for the week.
  • From a passing car, downtown Detroit looks much the same as it has for years–rutted streets, empty storefronts, ruined buildings, with the fortress-like Renaissance Center looming overhead in rebuke. A disturbingly high number of scary-looking people stroll the streets. This is the Detroit the national media has covered.
  • At ground level, at a slower pace, signs of rebirth emerge. Walking past the old Federal Reserve Building, I’m suddenly in Campus Martius Park–and I’m in the middle of a big, thriving city. People spill out of the Quicken Loans Building, with its big glass front. The decision by Dan Gilbert to move the company downtown, seen as risky at the time, is now seen as visionary. Young tech workers, wearing headphones, dressed in “skinny casual” breeze by, walking in all directions. This generation doesn’t lift weights.
  • Each block has its own panhandler, each with a different approach. Aggressive; supplicating; faithful; silent; wheedling. These are the people who are being left behind by Detroit’s tech-enabled renaissance. Some of the passing young tech workers give the panhandlers money and some don’t. Nobody has a long-term solution for them.
  • The pace of development is so fast that fully leased, renovated offices stand beside gutted shells. They’ll probably be finished and rented next week. When Dan Gilbert speaks at TechWeek, he says that there is 95% occupancy in the 40-some buildings Rock Ventures has bought and refurbished. He also makes a point of talking about downtown security. He reads a report nightly, and there is much less crime than people think. Rock has its own security service, highly visible on Segways. He doesn’t say it, but the implication is that the decimated public safety department cannot be relied on. This is what it looks like when the private sector leads.
  • I arrive at the Hudson Cafe on Woodward, a breakfast place I found on-line. I have to pick my way over construction rubble, but it’s worth it. I instantly decide that it is a better breakfast place than anything in Cleveland, which the decor, food and coffee confirms.
  • I stop by The Madison Building 1555 Broadway Street, where I office when I’m in Detroit. It was the first building Rock Ventures bought and rehabbed–an old theater–and it is full of young tech companies from the Detroit Venture Partners portfolio. There is a good coffee shop on the ground floor, and a super rooftop party area.
  • Behind the Madison Building, on Woodward Avenue, is the office of Bizdom, the accelerator program that is part of the same family of Dan Gilbert companies. They’re full, too, in part from absorbing spillover companies from the Madison Building.
  • TechWeek is in the old Federal Reserve Building. There is a gutted area on the left where most of the action is, and an elegant marble lobby and elevator stack that is nicer than most offices I have worked in. Why did the Federal Reserve leave, anyway? How much did their new building–much further from downtown–cost taxpayers?
  • TechWeek is jam-packed–the exhibit space, the sessions, the corridors. Young tech workers mingle with a smaller group of older people who have weathered the storm and are smiling at Detroit’s rebirth. Others left, but they stuck it out.
  • Many of the young people I talk with or who are on the panels are Michigan returnees. They left after college to Chicago or New York or San Francisco. They were beckoned back by opportunity, by the desire to be part of something special, to be near family, and to raise their own families comfortably without having to be millionaires–though being tech entrepreneurs they all expect to be millionaires anyway.
  • There are some really good panels, but what everybody is waiting for is Dan Gilbert to speak. He begins at 2:30, some 1,500 people packed in to hear him. Dan has asked Greg Schwartz, founder and CEO of DVP portfolio company UpTo to join him on stage, but Greg doesn’t say much. “Nobody wants to hear me,” he tells me later, but Dan is subtly sharing the stage with a company he favors.
  • Dan talks about his vision for downtown Detroit. It’s staggering in scope, but I believe that it is going to happen. He says it will take some time to clear up the blight, but a lot has been done since the desolate night three years ago when I and some colleagues searched in vain among dark streets for an open restaurant at 7 pm.
  • The day ends with a reception on the rooftop of the Madison Building, a venue that holds a couple of hundred people. Congressman Gary Peters is a center of attention; a troupe of Venture for America summer fellows takes a picture with him. The sky is clear blue, with a few wisps of cottony clouds. It’s warm but with a breezy edge of cool. “San Diego weather,” somebody remarks. “Yeah, we have a hundred days a year of it,” somebody else says.

Something big is happening in Detroit. It’s not finished and it’s not perfect. There are bumps in the road–I suppose Rock Ventures will have to repave the city streets, too, given Detroit’s well-publicized fiscal problems. But it’s exciting and it is working.

Bizarro World Comes To The Solar Industry

Fans of DC Comics and Seinfeld will remember that “Bizarro World” has come to mean a situation or setting which is weirdly inverted or opposite of expectation. This is what immediately came to mind as I was reading an article about the Spanish solar industry in yesterday’s Wall Street Journal.

After heavily subsidizing the solar industry for years, the Spanish government has now completely reversed course and is charging citizens who have the temerity to produce their own energy a fee as punishment. They don’t call it a punishment, of course, but justify it as private individuals carrying their share of the load for maintaining the national power grid. The people who installed solar panels, being good citizens and supportive of government policy, are left a bit mystified by the whole experience–which is opposite of what they expected. One wag on the WSJ Web site has characterized this as “a tax on sunlight.”

Here, in brief, is the sequence of events:

  • Spanish politicians decided that it would be “good” to artificially promote the use of uneconomic solar energy;
  • The Spanish government massively subsidized the installation of solar panels at taxpayer expense;
  • People, being people, responded to the incentives by installing solar panels;
  • The Spanish economy went into a recession which both reduced demand for power and made government subsidies of solar energy impossible to continue;
  • To balance engorged budgets the Spanish government cast around for “new revenues” and decided to tax people who were producing their own energy with solar panels.

Dutiful citizens who responded to the noble goal of reducing dependence on carbon now find themselves scratching their heads in dismay at the capriciousness of politicians. Here is how one citizen responded. “After calculating the fee’s impact, Inaki Alonso opted to give away the three solar panels he had installed on his roof early this year.” (emphasis added).

The broader lesson here is that government policy is an inconstant basis for making investment decisions, whether at the personal or corporate level. People change; policies change; circumstances change; fads come and go—but company employees still expect to receive regular paychecks and investors still expect returns, irrespective of the shifting sands of public policy. Something that has to be subsidized may never be a good investment, and the subsidy may go away.

For these reasons, I never invested in cleantech or wanted to. My partners did, but were judicious in selecting investments that were not dependent on government policy. Richard Stuebi was particularly emphatic on this point.

At the microeconomic level, it is better to pursue customers who value a company’s products and services, and will pay for them, than to pursue government subsidies as a business model. At the macroeconomic level, voters should understand the limitations of a politically driven economy. That lesson is as germane at home as it is in Spain.

Government Is An Anachronism

In the last decades, technology has rolled through one sector of the U.S. economy after another, rationalizing processes like supply chains; enhancing factory productivity by replacing labor with automation like Linestream’s advanced motor controls technology; and creating new industries, new jobs, and tremendous wealth for the technologically literate.

Two sectors of the U.S. economy have been resistant to this trend: the federal government and the healthcare industry. Each has increased its share of the U.S. economy and added people as workloads expanded. The growth of Washington has been well chronicled; it has added jobs and wealth and, even during the mortgage bust and downturn, was the only metropolitan area where real estate prices rose consistently. The healthcare industry similarly has been adding jobs and has been touted as a bright spot in a weak jobs market—you have all seen the ads on television.

Perpetual growth in government and healthcare is not sustainable.  Both government and the healthcare industry have similar characteristics. They have been dominated by centralized, one-size-fits-all control from Washington, rules and regulations, and political decisions that defend old ways of doing things to protect them from market forces. This has inhibited innovation in both industries and driven up costs. While defending old labor-intensive business models has certainly increased jobs (which is what politicians care about) neither industry has matched its increasing costs to the U.S. economy with commensurate value creation.

The era of automatic growth in government and healthcare is coming to an end. Technology is now making it impossible for any industry to wall itself off from market forces, and this is all to the good. Both government and healthcare are experiencing pricing pressure, as the impasse in Washington clearly demonstrates. Government employment is down—albeit from a recently engorged level—and major health systems like the Cleveland Clinic and Vanderbilt University Medical Center have announced layoffs as reimbursement pressures ripple through the healthcare system.

While politicians in Washington argue and defend past solutions to past problems, industry is innovating. Yesterday Premise Data Corp. emerged from stealth mode to announce that it has created an inflation index that is an alternative to the Department of Labor’s Consumer Price Index (currently suspended due to the wrangling in Washington). Premise creates real-time inflation data using photos of store shelves taken by hundreds of mobile-device-empowered individuals.  Premise also scrolls through Web sites to gather price data. In contrast, the Department of Labor uses a half-century old centralized, top-down survey methodology for its CPI index.

During the government shutdown, businesses that depend on government statistics have been casting about for alternatives, and Premise Data Corp. is one such alternative. The question I have is: Once the small part of government that is closed reopens, will anybody notice? Or will we all have moved on to other, more current products and services that do a better job at low cost?

Similarly, healthcare systems are rapidly adopting information technology to improve productivity, lower costs, and improve quality. It is no accident that healthcare systems are laying off people at the same time that they are adopting big data solutions like Cleveland’s Explorys or infection control products from companies like Ann Arbor’s BioVigil.

In the next decade the healthcare system will become rationalized, and it won’t be due to Obamacare—although the politicians will take the credit. It will be due to technology.

Here’s one way to look at the struggle in Washington. The federal government’s business model is breaking down, and its ability to funnel resources to itself to be paid out in political rewards to supporters is being undermined. The real fear of the people in Washington may be that we, the people, will realize that we don’t need them for much of what they do at our expense and that technology and the private sector do a better job. Perhaps that’s why the battle in Washington is so fierce.

Here’s hoping at the end of the protracted struggle in Washington that the federal government is on a downward trajectory. It is too expensive; delivers too little value; and pulls too many resources from more productive uses in the private economy. It needs to be disrupted, rationalized and downsized. Why should it be immune to the productivity-enhancing technologies that have improved every other industry?

Crowdfunding, Marketing, Big Data and The Death of Direct Sales

I was sitting in Demo Day the other day at FlashStarts watching ten companies present. The event had been scheduled to coincide with the first day of Title II of the new JOBS Act, which allows companies to directly solicit investment over the Internet or through other methods of mass marketing. This overturns 80 years of regulation which prohibited mass solicitation of investors by companies raising early stage venture capital. The first presenting company, Crowdentials, helps companies comply with the new SEC rules, which still require that companies ensure that their investors are “accredited” or face the penalty of not being able to raise additional funding for one year (a death knell for start-ups).

It suddenly occurred to me that I was seeing another manifestation of a question that has been troubling me: what does the massive movement of commerce on-line mean for expensive direct sales by enterprise software companies? Multiple companies in which I have invested early stage venture capital have been wrestling with this question.

What fund-raising and enterprise software sales have in common, I realized, is that they have traditionally been direct selling activities—in one case because of rules, and in the other because of the complexity of selling software to enterprises. If a company wanted to raise money, it had to interact with people it knew or to whom it was directly referred and who also passed the test of being accredited investors.

Similarly, enterprise software selling was traditionally dependent on personal relationships between a salesperson and customer personnel. The best salespeople moved from company to company, and sold different products to the same customers over the years.

Direct fund-raising and direct sales are now both being eroded by the massive movement of people online. Our on-line lives enable us to affiliate with people and companies that share our interests, irrespective of where we live or who we know in our daily lives. We can see them, trace their social networks, and readily find ratings about them. We are entering the era when marketing will replace direct sales in most situations.

Why is this happening?

Direct selling (or direct fund-raising) is expensive, labor intensive, and doesn’t scale. It is time consuming, results are hard to predict, and customer decision processes are opaque. Growing a direct sales force requires a significant investment; half of the salespeople a company hires don’t work out, but it’s hard to predict which ones until the company has made a significant investment. Many fund-raising processes, similarly, end in frustration. Having financed multiple companies that rely on direct selling, I can tell you that it is frustrating for boards to receive sales forecasts and the explanations associated with them.

What is enabling the shift from direct selling to marketing?

The simple answer is the Internet, but there are several components to consider.

  • Privacy is dead, but transparency is increasing.

Far from enabling companies raising money or selling software to be anonymous, the Internet actually increases transparency, enabling investors or customers to evaluate them and the reputations of the people behind them, before ever engaging with them.

One company in which I invested has depended on direct selling and has had frustratingly long sales cycles and convoluted sales processes. Last year, a well-known technology company called, said that they had completed an analysis of available products, and had chosen this company. They were ready to buy, and the sale was completed very quickly. They had never engaged with anybody at the company!

Last month a company I know received an unsolicited term sheet from a New York investment group at a breathtakingly high valuation. Nobody at the company had ever engaged with the investment group! We have speculated that they had an investment thesis around the company’s products, monitored social media, and picked the company with the highest profile as an investment target.

A third company finds that its yield in direct selling has reached historic lows. People aren’t responding to e-mails or answering the phone. The first time the company often hears about the prospect is when an RFP is issued.

What happened?

  • Buying is replacing selling.

In all three cases, enough information was available about each company on the Internet to enable analysts, who knew nobody at either company, to conduct a thorough assessment without ever engaging with the company. Social media rankings and quality ratings were certainly a part of the analysis. This is a recent phenomenon, probably just emerging over the last year, and still in its infancy. The ability to do this type of analysis is one benefit of big data and the tools that turn it into useful information. (As I was writing this post, an article in the Wall Street Journal confirmed my suspicions about what is happening: If You Look Good On Twitter, VCs May Take Notice.)

Investments used to be made, and software used to be bought, based on the trust developed in personal relationships between individuals. There is now so much information available on the Internet about us all (yes, privacy is dead) that investors can learn about companies, and companies can learn about software, without direct sales presentations.

  • Geography is becoming less important.

Formerly, companies raised investment in their communities, where they were known, and enterprise software was sold by salespeople who spent their careers developing relationships with particular companies in the territory in which they lived. Where you live and where a company is based are becoming unimportant in investment and sales decisions.

  • The Internet is becoming a video medium

One reason that geography is unimportant is that the Internet is creating platforms on which people can interact based on interests and preferences and video enables face-to-face interaction.

  • Investors and customers are overwhelmed by information.

VCs and angels have an excess of deal flow, and company personnel who have a role in buying software receive hundreds of emails and dozens of phone calls each week. (I receive multiple phone calls and dozens of e-mails per week trying to sell me cloud-based software, IT outsourcing services, or something similar and I don’t buy any of these items, causing me to question whether these companies direct selling efforts are effective.) It’s impossible to even read all the material, much less make sense of it. Deal flow has always been filtered through trusted referral sources, but now it’s also being filtered by accelerators.  Similarly, the software sales dynamic is shifting from responding to sales solicitations to reaching out to solve a problem.

  • Corporate security is enhanced due to 9/11.

Everywhere I go now, you need a badge to get into buildings, or to be escorted by somebody with privileges. One software company CEO who came up through the sales ranks, says, “I used to be able to get into every building on the Ford campus, except the R&D center, and wander around seeing people. I can’t even get on the campus now.” The way in today is through cyberspace.

I think what we’re witnessing is the death of direct sales (in most circumstances) and its replacement by sophisticated marketing tools.

What should companies that are raising funds or selling products do? Clearly, marketing is becoming more important. The ability to project a brand onto the Internet and to be distinguished from the clutter will be important to both fund-raising and selling. Here are some recommendations for any company raising money or selling a product or service:

  1. Make sure your product or service (if you’re raising money, it’s the entire company) is solid and will withstand Internet and on premises due diligence. This means going beyond the traditional methodologies and incorporating social media monitoring software, such as Radian6, to evaluate your on-line presence.
  2. Be very careful before investing in or expanding a direct selling operation. Make sure you have a repeatable, cost-effective model before embarking on a hiring spree.
  3. Be expansive in hiring leading edge marketing talent. Invest in the people and tools to create marketing or fund-raising campaigns that break through the clutter.

Will direct sales survive the Internet? Probably, in some places and at some level. Complex enterprise sales will likely always require hand-holding on the customer side. Parts of the international market are slower to catch on to trends discussed here than U.S. companies and, for cultural reasons, will be slower to abandon personal direct selling. Eventually, though, the cost of direct selling will be too high compared with the cost of effective marketing and direct selling will become a niche approach to reaching customers.

Wealth Creation is A Precondition of Job Creation

I was pleased the other day, while attending Demo Day at FlashStarts, to hear founder Charles Stack state that the goal of the accelerator and each of its companies was “wealth creation.” That was the only goal he discussed, and he pointedly mentioned it several times.

For the last decade I have participated in and supported many initiatives to remake the economies of Ohio and Michigan into entrepreneurial ecosystems, including engaging in early stage venture capital investing. Many people from the private, public, and non-profit sectors were involved in creating many programs and activities, including:

  • Technology investments from Ohio’s Third Frontier program
  • Funds-of-funds such as the Venture Michigan Fund, the Ohio Capital Fund, Renaissance, Cintrifuse, and the 21st Century Jobs Fund
  • Incubators, accelerators, and entrepreneurial assistance organizations like BioEnterprise, Ann Arbor Spark, JumpStart, and NextEnergy
  • Enhanced technology transfer at the region’s universities
  • Formation and support for pre-seed and seed funds
  • Loan and equity investment programs directly from Jobs Ohio the Michigan Economic Development Corporation, and Cuyahoga County…
  • …and many more.

Most of these activities have been supported by non-profit foundations and by taxpayer funded programs administered by government. Never once have I heard a public official or a representative of a non-profit organization state that “wealth creation” was one of their goals (although I was pleased to see Cleveland’s foundation community well represented in the Demo Day audience). And therein lies a fundamental difference between the objectives of the private sector and the public and non-profit sectors.

For politicians and people in the non-profit sector, the overriding interest is “jobs.” “Jobs” is the goal discussed in every speech and news release and the central variable measured in progress reports. It is the obsession of the media and of critics of the above programs.

What I have never understood is how jobs are supposed to be created without wealth also being created. I understand that government spending can temporarily create some types of jobs and that many people want to believe that having government create jobs and give them to people is the way to alleviate unemployment and create economic growth. All of the research, however, shows that this approach doesn’t work: these jobs cost more than they repay, and they require ongoing subsidies.

We have just gone through a cycle in which government spent huge sums of money to move the unemployment needle, without much success. It is true that some individuals and companies can do well by feeding off of government spending, but it is an illusion to believe that jobs created by crony capitalism are self-sustaining. Money must be taken from productive sources to continue subsidizing them.

Unfortunately, there is a divide in American society: in the public sector, media and non-profit worlds, the words “profit” and “wealth” often carry negative moral connotations. The pursuit of these objectives is deemed to be “greedy” or exploitative. That’s one reason that the public sector tries to create jobs without creating wealth.

In the private sector, businesses and business people understand that profit and wealth creation are the measures by which they can determine that they are serving customers and creating sustainable companies and employment. Yet, the business community has been  put on the defensive by a public and media assault on profit and wealth.

Over the last decade, I have spoken often about the need to publicly support wealth creation. I haven’t had much support on this subject; maybe I have been traveling in the wrong circles. It’s good to have Charles speak up, and he is doing so with his own money and investor money.

Wealth creation must be the goal in entrepreneurial ecosystems. When wealth is created, so are jobs. Wealth is what will feed government coffers and the endowments of foundations. It is a virtuous cycle when it is working properly. Except in pockets of our economy, as Richard Florida points out in The Atlantic Monthly, we are not creating enough wealth.

It’s time to fight back and speak the truth: If America wants to create economic growth and new jobs we must embrace profit and wealth. There is no other way to get out of the economic doldrums.

Why I Like Mid-Career Entrepreneurs

Earlier this year I was asked to participate in a business plan competition at one of Cleveland’s elite private schools. The format was a “Shark Tank” and, like the television show of that name, the idea was that a group of investors would bid on which student companies they wanted to back. After a little competition between the investing teams and back-and-forth with the entrepreneurial teams, the general idea was that all money would be invested and all companies funded.

I was one of the investors but since there are only a few early stage venture capital investors resident in Cleveland, the investing teams were rounded out by people from accelerators, small businesses, and non-profit organizations. I was teamed with three people I didn’t know, none of whose retirement income was dependent on the quality of investment decisions they made. Each of the four investing teams was given a fictional $1,000,000 to invest in the seven presenting companies, each with up to five team members.

I was impressed that a high school was teaching entrepreneurship and that so many bright students would take the time to develop and pitch a business plan. Schools have over-emphasized preparation for academic colleges in the last 30 years, but many people aren’t suited to that type of education—and we’re seeing that there are fewer suitable jobs on the other side of an academic degree than there are people receiving such degrees.

Many successful entrepreneurs never went to college or, like Bill Gates and Mark Zuckerberg, never completed college once enrolling and comparing college with entrepreneurship. I noticed when getting my MBA at the University of Michigan that most of what the professors taught us was based on field work observing successful businesspeople, many of whom didn’t have MBAs. That observation was one my own forks-in-the-road in pursuing an entrepreneurial career over the false security of big company employment. On graduation, I picked up and moved to Silicon Valley with no job.

The student presentations were generally good, though necessarily immature. Most of them were “me too” ideas that were based on needs that teens could see in their lives, but which could be easily conceptualized and duplicated by other people. Most had flaws in their analysis of market, distribution, sales process, IP, or capital requirements. That was to be expected; the students had been given only a semester to take an idea and develop it, had no entrepreneurial experience, and had other academic and extracurricular commitments. The students were smart and hard-working and the teams had been well balanced in gender and ethnicity. They had been coached to give each student a speaking part in the presentation.

There was one exception to all the rules, a business that two introverted nerdy male students were already running—a videogame company with a product and customers.

After each of the teams pitched, the four investor groups were sent off to confer and prepare their bids. I immediately disconcerted my teams members by stating that I was only interested in investing in one of the seven companies—the one with a finished product and customers. This seemed to violate the intent of the event—as some people saw it—to get all the companies funded and to have a “feel good” outcome for everybody who competed. Some of my team members wanted to discuss, score, and rank each company, and I went along with the exercise.

Time was short, though, so we were called to begin making offers to companies. I made a beeline for the gaming company, but another investor group had gotten there first. Another presenting company stopped us and, in the interest of playing the game, we engaged with them.

They thought that their business idea was worth $400,000, and that we should invest $100,000 for 20% of the company. It had been one of the better ideas, but would have required a lot of work, a number of experiments to test assumptions, and a pivot or two. I decided to throw them a curve.

“Okay,” I said. “I get that you believe in this idea and in your ability to pull it off. You’re committed. So how about if we give you the $100,000, but we own the company and you earn your equity stake, over time, by achieving milestones.” A moment of stunned silence followed—this was clearly not what they expected. The rules were that investors were supposed to offer an amount of money for a percentage of the company, followed by a negotiation and a deal.

When evaluating a company I always—always—challenge one of the team’s assumptions to see how they will react. I’m observing the human behavior associated with responding to the unexpected, because this tells me something about how the team will respond to the inevitable twists and turns of pursuing an entrepreneurial endeavor. This is a deliberate, considered, and intentional part of my due diligence process. In some quarters this has branded me with being aggressive or arrogant with entrepreneurs. Nevertheless, I consider this to be a necessary step in being a good steward of the capital that my own investors have entrusted to my care. After all, an investment in a company is an investment in the people running it.

The team members looked at each other for a minute. I saw one or two nods, some averted glances, and some shuffling of feet. They weren’t prepared to respond to my question. Then one of the team members spoke up and, in a voice only a teenage girl could use to dismiss the obviously ridiculous, said, “No, it’s our idea. You have to buy into our company.” She wasn’t looking at me when she said this, or at her team members. Her lips were pursed and her body language betokened impatience. I now knew how this team functioned. There was a nervous flutter as her team members contemplated the aggressiveness of her response, and then one of the coaches called “time” and we switched off to another company.

Our culture and media extol youth, particularly in entrepreneurship. Though I appreciate and enjoy the young (including my two wonderful kids) I find myself gravitating towards mid-career entrepreneurs in my investment decisions—after experience with both young entrepreneurs and mid-career ones. Why is that, I have asked myself?

There has been a flurry of research recently on the concept of “10,000 Hours:” that it takes ten thousand hours of practice to become good at something. I believe this. Fifteen years ago I joined my church choir, after being a secret car singer. I didn’t read music (which I didn’t admit) and had never sung publicly or in an organized group. It took me about five years to learn how to fully read a piece of music. Only after eight years did I have a sense of what it meant to create beautiful sounds—how to use the diaphragm, throat, tongue, and lips to control exhaled air, when to go loud and soft, whether the piece was written to sound like brass or woodwind.

I had a similar experience developing competence in venture capital investing, in working with my son to become a second degree black belt in Tae Kwon Do, and in working with my daughter to learn how to figure skate (yes, I took up both sports in mid-life). Results don’t just show up immediately, or because you want them to, or because you’re smart or deserving or talented. You have to put in the time to develop competence, to make and learn from mistakes (in Tae Kwon Do that looks like being kicked by a large teenager; in figure skating, like falling hard on the ice), and to learn what it means to persevere.

I like mid-career entrepreneurs because they have invested their 10,000 hours in learning how to be businesspeople. By the time they come to me, most have experienced enough of the ups-and-downs of life to be ready to focus on those things that are necessary to achieve success, and to put aside those things that are unimportant.

Our society needs an entrepreneurial economy. That’s where the job creation and wealth creation occur that enable us to finance everything else we want to do as a country. But venture capital, as a product, is too precious to be deployed teaching people–like the young woman who dismissed my idea out of hand—how to be entrepreneurs. I did this once—I called it buying an MBA for the entrepreneur—and it wasn’t a successful investment. I will only invest in young, first-time entrepreneurs again under defined circumstances.

Where are young people going to get capital for their enterprises, then? The good news if you are a young entrepreneur is that there are more resources than ever to help you: entrepreneurial programs in high schools and colleges; accelerators; angel investors; seed funds. Plus, the Internet and new technologies have made it possible to start a company, especially a technology company, with less capital than ever before.

By all means, please send me your decks and reach out to me for feedback and to develop a relationship. Don’t pitch me, though. I’ll see you at the accelerators where I volunteer my time. Remember,  venture capital invests only in one out of a hundred ideas that it sees. Your odds are not good—unless you have put in your 10,000 hours.

Oh, and by the way, we didn’t get the investment in the gaming company. Another team, led by a young employee of one of the local accelerators, gave them a higher offer. We would have raised our offer to match or beat that deal, but it didn’t occur to the young entrepreneurial team that they could come back to us to negotiate a higher offer. They thought they had only one bite at the apple. Ah, experience. The young accelerator employee, by the way, invested all of his money; we invested none of ours (to the disappointment, I think, of some of my teammates). That is one difference between the accelerator model and VC investing.

The Emergence of “Human Capital Management”

I had dinner a couple of nights ago with two of my favorite executives, the CEO and COO of an enterprise SaaS company in which I invested early stage venture capital. The CEO rose through the sales ranks, and the COO through what used to be called HR and is now being called HCM—human capital management.

I have always liked sales-oriented CEOs because they are focused on customers and measurable results. The good ones spread these orientations throughout the organization, creating a culture attuned to customer service and accountability. This is the first company I have worked with, though, where the number two executive has risen through the HR ranks—and I’m surprised at what a good decision this has turned out to be. We talked a great deal about the shift from HR to HCM and how this reflects on modern personnel practices, especially in technology companies.

When I went to business school, HR was not the choice calling of most of my classmates. It was a backwater focused on administering benefits and avoiding corporate liability—not central to the MBA educational process—or so I thought then.

That is no longer the case.  The functional area has clearly been elevated. Talent acquisition, training, assessment, and retention are no longer backwaters, but are strategic to forward-looking companies.

There are many reasons why HR has become HCM, including better data on what drives strong company performance. Culture is increasingly understood to be important, and this particular company places a big emphasis not just on hiring good people, but on hiring people who fit and quickly weeding out ones who don’t. Yes, top performers are significantly more productive than average ones, but cultural misfits can be disruptive and hinder team productivity, no matter their individual performance. Bad hires are expensive because they have to be replaced, any holes they leave need to be filled, and any damage they have done repaired.

Watching this company, and learning from this team, I have become a convert to modern talent management practices. Apparently, I’m not alone, and am probably behind the curve.

Anybody who has been following the emergence of enterprise SaaS has seen the speed with which the HCM sector has emerged. SuccessFactors pointed the way, growing from startup in 2001 to $330 million in sales before being acquired by SAP for $3.4 billion in December 2011—that’s right, the acquisition price was 10x revenues. Not to be outdone, Oracle followed in February 2012 with a $1.9 billion acquisition of Taleo for 7x revenues. Not content to sit on the sidelines as SAP and Oracle bought their way into the cloud, IBM bought HCM company Kenexa for $1.3 billion in August 2012; the company was on a run rate of about $250 million in revenues—a relatively inexpensive 6x multiple.

HCM SaaS companies also have been well represented in the IPO market. Workday, founded by former executives from PeopleSoft, went public in October of 2012, and is now valued at $12 billion dollars—more than 34 times trailing 12-month revenues of $350 million. CornerstoneOnDemand, another HCM company that went public in May 2011, sports a market cap of $2.6 billion, a multiple of 16 times trailing 12-month revenues of $150 million.

There are also dozens of smaller privately-held HCM companies, many of which are growing at annual rates of 50% or more.

How can there be so many successful companies in this emerging market? There is clearly enough demand to feed them all.

These are all companies that, in one way or another, help businesses to attract, train, motivate, and retain the best people. I haven’t done the math, but it feels to me that if you added up the revenues or market caps of all the HCM companies in the enterprise SaaS industry, it would be the largest sector.

All in all, it was a pleasurable dinner. These two executives have been very intentional about elevating culture in their organization, and that decision—supported by the board—has produced very good results. I’m reminded of this every year at their Christmas party, which feels like a family gathering. Each year they have an artistic contest of some type—most creative door covering, for instance—and it is amazing to see the energy that people in every functional area put into letting their creative sides run free. You can’t predict who will have the most artistic creations based on their job functions. I take this as a sign that people are comfortable being themselves in this environment.

Why Expensing Stock Options Makes No Sense

In the third of my three posts on stock options, I would like to address the issue of expensing stock options on a company’s income statement. I think that this policy, which was developed by the Financial Standards Accountability Board (FASB) as FAS 123r, is nonsensical.

The decision to expense stock options had its origins in the period following the Enron and WorldCom scandals and the bust. Congressional hearings were held to uncover the causes of the scandals and one focus of legislator and media outrage was people making money through stock options—though options were clearly not causative of the scandals. You may remember that no less an eminence than Steve Jobs was investigated by the SEC regarding options he was issued by Apple’s board.

What followed the decision to expense stock options was a decade in which fewer stock options were granted to fewer people, which has been documented in at least two studies. That can’t have been the public policy objective.

No Sense, or Nonsense

Here is my analysis of why expensing stock options makes no sense, particularly for the companies that have received early stage venture capital. Let me begin by confirming that I am not an accountant; I don’t want to be an accountant; you don’t want me to be an accountant; the world doesn’t want me to be an accountant; the world probably has enough accountants already; and, my favorite accountant is Bob Newhart, who famously left the profession (involuntarily) because “getting within a few dollars was good enough for me.”

But I do know enough about accounting to believe that the accounting treatment of a transaction should follow the substance of the transaction, and that expensing stock options does not follow the substance of the transaction. It attempts to make an income statement item out of what is actually a balance sheet item.

Argument For Expensing Stock Options

The argument for expensing stock options is that they are a form of compensation and should be treated like cash compensation as a current-period expense against income. Warren Buffett made this argument to Berkshire Hathaway shareholders as early as 1998.  (He is not an accountant either.)

If employees didn’t receive stock options, this line of reasoning holds, companies would have to pay them more in cash. This is the main argument buttressing the policy to expense stocks options in the period in which they are awarded.

In large public companies, with which Warren Buffett is mostly concerned, this argument may hold true. Options are closer to cash compensation because there is a liquid market for large company shares and these companies are managed for steady, predictable earnings. Options are granted at market prices and the rise in their value is as predictable as is the rise in company earnings.

The federal mind finds comfort in the orderliness and predictability of steady results at large companies and tries to spread these results throughout the economy by promulgating rules, including for smaller, more volatile public companies and private companies for which the argument doesn’t hold true.

Argument Against Expensing Stock Options

There is little market for private company shares. Stock options in these companies are inherently risky. The value of options is based on a 409A valuation that is highly dependent on assumptions. They will be worthless if the Strike Price* is under water when the options mature. If the private company fails, or is acquired at a price below the option strike price, or is never acquired, the options are worthless and the previous expensing of the options is shown to have been arbitrary.

Smaller public companies are somewhere in between. The market for their shares may be limited. Earnings may be less predictable, and share prices may be more volatile. Options are, therefore, more at risk than is the case in large public companies.

As these three scenarios suggest, the problem lies in a “one size fits all” rule that is best suited for large public companies.

When stock options are issued, they have no cash effect on the company (besides a de minimis transaction cost that we will overlook). Therefore, they don’t affect a company’s income statement or cash flow statement. The options are a contingent claim on the company’s shares, i.e., the company must issue additional shares to the holders when options mature and are exercised.

Make Sense

If the granting of options is not, as I am arguing, an expense, then how should they be accounted for? The substance of the transaction is that issuing stock options has no cash effect on the company. When they mature and if they are exercised, they dilute existing shareholders (whose percent ownership declines predicated on the number of new shares issued). All other things being equal, the value of outstanding shares will fall by the value of options exercised, minus the cash received by the company for the option strike price. Earnings per share (EPS) will also decline by a like amount.

The likeliest effect of  issuing stock options will be to increase the company’s cost of capital—to the extent that the company raises capital by issuing new equity rather than debt.

From an accounting standpoint, it should be possible to calculate a company’s cost of capital considering the cost both before and after options are granted, and providing a footnote to help shareholders understand the consequences of stock options on their ownership interest. And that’s what I think should be done.

I would like to see a return to the day when stock options become a more widespread way for people working in companies to benefit from the share appreciation in those companies.  Changing the accounting treatment of stock option grants to more closely mirror the substance of the transaction would likely reverse the decline in option grants and have the effect, once again, intended for stock options–to spread the wealth more widely.

*The strike price is the price at which a holder of stock options can turn them into actual shares. It is supposed to be Fair Market Value (FMV) at the time of grant. If a public company’s common shares are trading for $10, the FMV for the option at the time of grant is $10. For a private company the math is more complicated because there is not a ready market for trading its shares and there may also be multiple classes of preferred shares with seniority to the common shares into which stock options generally convert. Private companies attempt to establish FMV by using the last round of investment—if within 12 months—or a calculated FMV based on the Black-Scholes model.   Since private companies often have multiple classes of shares, including Preferred Shares, the FMV strike price for an option may be well below the price at which preferred shares were last bought.  “Underwater” means the strike price for the option is below the current price of the shares themselves and there is no incentive to exercise the option; it is worthless.