Dear Mr. President,

I feel compelled to write you a letter to express my thoughts and frustrations regarding innovation policy in our country.  While I have modest expectations that you’ll actually read this, perhaps someone in your inner circle will and represent my thoughts.

First of all, I hope that you realize how very fortunate we are as a country to have an innovation and entrepreneurial engine at the heart of our economy.  It is part of our culture and is a pervasive mind set that is the envy of the rest of the world.  Furthermore, it was not created, nor is it (currently) regulated by the government.  If you look at the venture capital industry as a proxy (since many innovative startup companies need some financial backing to prosper), one can see how important this ecosystem is.  The latest report from the National Venture Capital Association called "Venture Impact" talks about the important of venture-backed companies in the macro U.S. economy.  Among the highlights:

- Venture-backed companies employed more than 12.1 million Americans in 2008;
- Venture-backed revenues were $2.9 trillion in 2008, equating to 21 percent of US GDP; and
- Venture backed companies grew jobs and revenues faster than their non-venture counterparts from 2006-2008.

Best of all, none of this costs the government anything, nor does it require any bailouts.  The jobs created in this country are real, high paying and reflect the newest opportunities in the world economy and aren’t shipped overseas.  One would think that you would want to do everything in your power to encourage growth in the innovation sector and make sure current proposals don’t unnecessarily negatively impact this gift that our economy has been given.  So I propose to you some things that your administration should and should not do.

What your administration should do:

1. Reform immigration policy.  My partner Brad Feld wrote a post last week on the "Startup Visa Movement," based upon the earlier writings of Paul Graham.  The basic premise is this:  we should openly encourage and enable people from different countries to move to the United States, start companies and create jobs.  Clearly, there would need to be some limitations and thresholds to ensure that the companies created were "real," but I am frustrated by how many foreign founders are being forced home due to our overly-restrictive policies.  I’ve seen two companies this year in Boulder, Colorado, that would have received U.S. venture funding and stayed here, but won’t be able to.  There are many of such cases across the country.  

Also, we still don’t have a handle on the H1-B issue.  Every year, our U.S.-based investments struggle to hire all of of the computer science talent that they need and their growth is stunted.  It’s time to de-politicize the immigration debate and concentrate on ways that we can make this country’s workforce even stronger. 

2. Enact real patent reform.  There are many points of view out there – from abolishing some types of patents, to materially revising the way jurisdiction is handled in patent cases, but, regardless, the loud chorus from the innovation economy is that the patent process is not working.  Patents are too costly to obtain, are too uncertain in the rights they grant when obtained and then all too often, end up with meaningless lawsuits that amount to nothing more than a tax on innovation in favor of lawyers.  We need to clearly define what is patentable and what should not and re-architect the system to deal with the realities of a connected world.  

3. Push for FASB to "figure out" valuation methodologies.  Over the past few years, venture funds have had to "mark to market" their investments.  This "FAS 157" (or Topic 820, as it’s been recently renamed), has placed a tremendous burden on venture firm managers and their investors.  In short, not even the accountants can tell us how to accurately value our portfolios and there is tremendous cost and uncertainty about the asset class because of it.  I’ve written about the issues, here, in detail.

4. Get a handle on Sarbanes Oxley / help with opening of the capital markets.  The last financial meltdown earlier this decade brought about increased regulations through Sarbanes Oxley.  While some credit the act for deterring and lessening fraud in public companies, it’s easy when almost no companies are going public.  In my opinion, the frauds perpetrated in the most flashy cases (Enron, Worldcom, etc.) were the work of bad actors and lazy accountants.  They were not systemic in the industry and even the rules today can be easily circumvented by two unscrupulous executives with a criminal agenda.

What the effect has been is to stop the flow of companies going public which has greatly hurt venture capital returns and has driven venture firm investors (limited partners) out of the market.  This has severally constrained the amount of capital able to fund new and innovative businesses.  I think a complete review of all of these rules needs to be undertaken, as I’ve had many conversations with entrepreneurs who don’t even want to go public due to all the red tape involved with Sarbox. 

The secondary effect has been a rush to other foreign markets, whether they are in London, China or India and thus the U.S. is losing its market share of new offeringings and further weakening our financial industry.  

What your administration should NOT do:

1. Regulate the Venture Capital Industry.  We aren’t hedge funds.  Nothing we do increases "systemic risk" in the economy.  In fact, the entire VC industry invested a total last year of $28 billion dollars (not an atypical year).  That sum is less than half the amount that Bear Stearns was borrowing every night before its collapse.  Regulating us, in the best case, foists additional costs upon us that smaller, early-stage VCs can’t afford and worst case, materially and negatively impacts the VC industry’s ability to fund new companies.  Lastly, it should be noted that investors in VC funds are of the highest sophistication levels.  This isn’t the case of protecting the average investor.  The WSJ recently had a great opinion piece supporting this position. 

2.  Increase taxes, especially capital gain taxes.  There is quite a bit of research that shows correlations between low capital gains taxes and high GDP growth rates.  I won’t pretend to have a PhD in economics (although I did manage to get an undergraduate degree from the University of Michigan in it), but many of the entrepreneurs I speak to say they specifically take the outsized risk of starting a business because of the potential financial gains.

Additionally, changing the characterization of venture capitalist’s carry is inconsistent with how VCs invest – long term with high risk of capital loss.  I also have a hard time delineating between founder shares and VC carry and wonder if VC carry is changed will founder shares be next?  The reason behind capital gains treatment was to incentivize long term investing and also to help make up losses from risky asset classes that benefit our society in the long run.  This is precisely what VCs do. 

3. Engage in activities that will devalue the dollar.  One thing to keep in mind is that with some of the current issues detailed above, it is harder and harder for VCs to raise money to fund startups.  Small businesses must do more with less.  If the dollar becomes devalued, these companies would effectively have less money to spend on hiring and other activities to make them successful in the global marketplace.

Again, Mr. President, I urge you to consider how your policy makers are taking into account one of the most important drivers of this country’s economic future.  This is not about venture capitalists:  it is about the ecosystem of innovation which venture capitalists spend their lives funding.  We’ve been blessed in this country with a large population of entrepreneurs and we need to foster this culture so that we can maintain our competitiveness as the greatest economy in the world.  To that goal, the government can largely stand out of the way and help on the margins to tweak some things that will benefit all. 

I humbly ask for your consideration. 

For those of you who share my disgust with the current patent ecosystem, here is a great piece from Timothy B. Lee on “Intellectual Ventures.”

I use quotations, because it’s nearly impossible for me to call them “Intellectual Ventures” as I see nothing intellectual about the firm but for their desire to further deteriorate innovation in this country while trying to bilk a buck or two (or millions) from hard working entrepreneurs.

Timothy summarizes Malcolm Gladwell’s expose of IV where he stated that IV

“hires smart people to participate in brainstorming sessions and then has patent lawyers immediately file patent applications for every idea that comes up during the discussion, without bothering to actually implement any of them, or even devoting much effort to verifying that they actually work. IV then approaches firms that are doing the hard work of implementing “their” ideas and demands a cut of their profits.”

If you aren’t disgusted, you should be.  Timothy asks how any of this benefits anyone other than IV and the patent bar.  His take on patent reform?

“a good yardstick would be to look for policy changes that would tend to put Myhrvold and his firm out of business.”

Brilliant. 

Adam Smith may have written the Wealth of Nations and been a seminal economist underpinning our capitalist thinking, but evidently his name-saked website about law firms doesn’t understand crap about law firm economics. 

Yesterday, The Wall Street Journal printed an Op-Ed about The End of Big Law.  In short, the author argues that we’ve seen the end of the big law firm as we know it.  It’s a must read for anyone interested in the subject.  Any reader of this blog knows that I’ve been predicting this for quite some time as part of my Law Firm 2.0 series. 

Today, however, I read one of the worst rebuttals I’ve ever read.  Adam Smith, Esq. is a website that purports to be experts on the economics of Law Firms.  According to their site, they provide consulting services to Big Law firms, so clearly there is no bias there, right? (sarcasm intended).  You can probably guess that they argue the the End of Big Law is a myth. 

The "rebuttal" (in quotes, because it really doesn’t deserve the description) is that Big Law is just like any other industry hit by the recession.  What they are missing are the massive changes that have taken place in the past decade in the Big Law ecosystem.  I won’t go into detail (if you want detail, read my Law Firm 2.0 series), but how can supposed experts on law firm economics not see that these changes are only being hastened by the recession, not caused by it?  The changes started a long, long time ago.  The recession is just putting the nails in the coffin. 

Secondly, any credibility the author may have is completely destroyed in my mind by two ridiculous assertions:

1. "I have yet to meet a managing partner not exquisitely attuned to the sentiments of their partners and the perceptions of their clients.” You clearly don’t get out much then.  This is absurd.  If this statement was true, one would not see the massive amount of partner transfers between firms and pissed off clients.  I am confident when I say that the majority of clients think exactly the opposite and disagree that law firms are "managing their firms as smartly as they are" (quoted from a previous Adam Smith blog); and

2. "Last time I checked, we were not capital-intensive nor do we have but the most trivial base of fixed assets." This is also laughable.  First, I find it enlightening that the author uses the word "we" when referring to Big Law.  Clearly this is another tip of the cap to bias.  Secondly, law firms are notorious for getting in over their heads with fixed assets.  See: Brobeck and / or my prior posting on this.  And this doesn’t include the multiple of dozens of conversations I’ve had with AmLaw 50 partners agreeing with me that fixed costs are out of control. 

This blog is simply reinforcing what’s broken and wrong in the legal environment.   Me, I’m happy to see articles like this, as it emboldens me as a venture capitalist to exploit and profit from the inefficiencies of the market. 

Lastly, the Adam Smith post accuses the WSJ article of being  "a truly impressive exercise in the abject failure of critical thinking" and likens it to a "tabloid."  I’d call this a case of the pot calling the kettle black, but in this case there is no kettle. 

My favorite IT guy, Ross Carlson clued me on a recent lawsuit whereby a landlord is suing their tenant over a tweet whereby she besmirched their name.

The tenant tweeted that her apartment was moldy and that her landlord thought it was okay.  Despite her having only 20 followers, the landlord claimed "damaged business reputation" and has sued her for $50,000. 

Ugh.  Note to landlord and lawyers:  get a life.

I suppose that I should be on the lookout from AT&T and/or United for lawsuits against me for all the horrible things I say about them on Twitter, but then again, all of my claims are true.  So maybe I’m still safe. 

As an added bonus, I’ll leave y’all with this lawyer joke (Thanks to Gabor Garai for this one):

One afternoon, a wealthy lawyer was riding in the back of his limousine when he saw two pathetic-looking men by the side of the road, eating grass. He ordered his driver to stop and got out to investigate. He asked the men, "Why are you eating grass?"

"We don’t have no money for food," the first man replied.

"Then you must come with me to my house," insisted the lawyer.

"But, sir, I got a wife and three kids here," said the man.

"Bring them along!" replied the lawyer.

The second man exclaimed, "I got a wife and six kids!"

"Bring them as well!", the lawyer proclaimed as he headed back to his limo.

They all climbed into the car, and once underway, one of the men expresses, "Sir, you are too kind. Thank you for taking all of us with you."

The lawyer replied, "I’m most happy to do it. You’ll love my place. The grass is almost a foot tall."

Every once in a while, I read something and go "huh?"  The most recent was the report that 52.9% of venture capitalist think that VC is broken.

Per my post, I don’t think the model is broken and am disappointed in my colleagues who think it is. 

Today, I read another article about VC being broken in BusinessWeek.  The author believes that the VC model would work better if early-stage investors bought early and sold out to secondary funds before the companies ultimate exit.  He then argues these secondary investors make better board members of later-stage companies.  Huh?

This is absolutely the wrong thing to do.  It make no sense.  This why:

1. Secondary Buyers Never Pay Full Value for Shares.  I’ve seen a lot of secondary deals and even in the "named" transactions (Facebook,etc.) the secondary guys enter in a 50% discount to current value of the shares.  In other words, whatever value I’m carrying the investment at, I should expect to get 50 cents on the buck.  I understand the strategy from the secondaries and would do the same if I were them, but that certainly doesn’t help my return.  From an investor (my investors) standpoint, I’d always be selling for half of value;

2.  There Are Very Few Companies that Fit the Profile.  All of the author’s examples talk about the extreme outliers in VC investing, so at best this is an edge case scenario.  In most cases, the companies aren’t in a position to attract a secondary buyer as they are still too risky;

3. VCs Should Hold Their Winners.  The corollary for number 2, above is that VCs make a massively disproportionate amount of their returns from these Black Swans and to sell them early would depress overall VC returns.  As the model has been shown to work, one needs to hold their winners, not sell them too early; and

4. VCs Make Effective Board Members.  I don’t know all the secondary funds, but the ones that I do are financial engineers, not company runners.  I would agree that our specialty is early-stage counsel, but that doesn’t mean that we have nothing to add later in the equation and I’ve seen no evidence that secondary buyers have more to add than VCs. 

I applaud anyone thinking out of the box to improve the VC industry, as clearly I’m interested in VC success, but this is not the way to approach the problems.  Yes, some VCs are broken, but I still think the model works. 

Great post on the Shareholder Representatives blog.  They had an escrow where they had to mail out checks of $.01.  They ask why this money shouldn’t go to charity?

I think it’s a great idea. 

From Dan Primack this morning, these factoids:

"More than half of venture capitalists (52.9%) believe that their industry is “broken,” according to a survey conducted by executive search firm Polachi Inc. Moreover, nearly 60% said that they are less confident in the VC industry today than they were six months ago."

You can read the full report here.

Having spent plenty of time bashing lawyers and the accounting profession, it’s only fair that I call out my own industry today.  Y’all are really confused.

The Industry Isn’t Broken

VC isn’t broken.  In fact, I would argue that there’s never been a more exciting time to be involved in venture capital.  I’m highly optimistic.  (Mind you that I’m a software / IT guy, so I’ll leave the cleantech and biotech opinions to others). 

What’s not to like these days? 

1. It’s never been cheaper to start a business with the advent of cloud computing resources, open source development environments and specifically today, low rents and the ease of hiring quality people;

2. Because of past successes, this country (as well as the rest of the world) is producing a lot of entrepreneurs.  Today, more than ever, our college graduates are creating their own opportunities, not just working for the incumbents.  These folks are scratching their own itches and creating companies of value (see everything from Facebook to Techstars);

3. We have more experienced entrepreneurs ever to fund.  Given the maturity of the industry, it’s much easier to find folks who’ve "been there, done that."  And with point 2, above, there has never been better deal flow and cool stuff to invest in;

4. VC is not a slave to credit markets or other systemic risks like other areas of finance.  While the popular press has dramatized that investors are defaulting on the VC commitments, I’ve spoken to many folks who think this reporting greatly overstates the issue;

5.  While the report says that nearly 70% of VCs are worried about their investor syndicate, this is something that should be in control of the individual VCs.  I understand that some VCs syndicate for extra brainpower around the board table (a good thing), but many VCs syndicate simply to validate their investment thinking.  This lemming approach isn’t good in its own right, therefore I don’t have a lot of sympathy for folks worried about it now;

6. We learned (or should have learned) a tremendous amount during the Internet bust period (2001-2004).  The VC industry essentially got a "free pass" and instead of just being thankful, we should have learned a lot of valuable lessons about building Internet and software businesses.  In short, we know how the next generation of companies should create value; and

7. Broadband, mobile connectivity and attention from advertisers exists today in ways that we envisioned 10 years ago, but finally is reality.

 The Industry Shouldn’t Analyze Itself in the Short Run

The report says that the past 6 months has deteriorated VC confidence.  What?  With all due respect to John Maynard Keynes (who said "in the long run we are all dead"), who gives a shit about 6months?  We are talking about an asset class in which each fund has a 10-12 year life span.  We are also talking about an industry that has proved its best returns are usually made on companies invested into during a down economic cycle.  Why shouldn’t we be excited about today?  If history does repeat itself, we could look back one day as this time period being one of the best for investment.

In short, if you are making decisions in VC based on trends and noise in a 6 month time period, you are in the wrong industry.  We need to be patient.  You can’t rush success and you can’t bet on "what might be" 6 months from now. 

Exit Markets

Alright, all you haters out there are probably saying "none of this matters Mendelson unless we have an exit market."  And yes, clearly, we need to have a vibrant exit market for us to achieve our financial return goals.

That being said, I speak to bankers on regular basis who think we are on the cusp of a wave of M&A.  They are on the front lines and one of them (who is normally the most pessimistic dude that I know) is practically giddy.

On the IPO front, it’s bleak, but we’ve seen a few companies get out and folks like the NVCA are putting their weight behind plans to restore liquidity in the industry. 

Unless you believe the entire U.S. economy is game over permanently, these markets will come back and they will allow us to meet our financial objectives.

So, there you have it – why more than half of VCs (surveyed) are confused/deluded/misinformed, if indeed, this presentation accurately represents their views that the industry is broken.  It’s not.  Invest in good companies with great entrepreneurs, stay patient, make our your investment decisions and the rest will take care of itself.  And if they still don’t like it, I’m happy to have less of them around – it certainly won’t hurt my business. 

*** I’ve had several comments about the VC industry being broken given that it got too big and raised too much money. I don’t think this is a fact of a broken industry, rather this is a situation that will be corrected. The industry will settle into a steady state. This is a bad fact, but doesn’t mean the industry is broken. ***

Last night word spread that FlyClear ceased operations.  I’m seriously bummed.  Clear was one of those small bright spots in my hectic travel schedule.

I don’t have any inside information from the company, but something doesn’t add up.  They claim that they had signed up over 260,000 travelers.  Since joining cost between $100 and $200 bucks that would put lifetime revenues in the $26m to $52m range.

So how does the company burn through all of that cash plus it’s venture funding when from a consumer standpoint their service amounted to a few folks at every airport helping you through security?

My only guess is that airports must have been extracting large sums of cash, or the TSA was bleeding them dry.  Or perhaps Clear was developing next generation screening technology and that created a massive cash burn.

Whatever the case may be, I’m really going to miss the service, as several flights would have been missed without them. 

Brad has a GREAT post today on preparing for a first meeting with him.  All I can say is "what he said."  If you are meeting with me / trying to get my attention, these are better tips than I could have come up with on my own.  After all, plagiarism is the most sincere way of flattery.  

The title isn’t as provocative as Michael Arrington’s "Jew Haters Welcome at Facebook, As Long As They Aren’t Lactating" but it doesn’t mean that it doesn’t piss me off.  (Read the article, it’s well done).

I’ve always hated double standards, but more than that hate purposely ignorant people, apparently some who are working at Facebook and allowing hate speech.

Shame on you, Facebook.  There is no logical excuse why you need to cater to the hatemonger clientele.