the double back theory

I have an old friend who swears by The Double Back Theory, which basically goes like this:  Any important revelation will immediately strike you as obvious and true, but because its significance lingers with you for years, you will have too much time to develop alternatives and corollaries that overcomplicate the picture. Nevertheless, if you keep on thinking about the central idea, you will inevitably double back to your original revelation as the most profound revelation.

Today’s example: The Internet is a new platform for consumer media. That’s a striking revelation . . . in maybe 1994 or perhaps as late as 1998. This may be hard to believe today, but there was a time when it was revelatory to describe the Internet as a new form of popular media, rather than as a niche technology.  Today most people would declare the Internet as the second most important form of media (behind TV).  It seems so obvious now that the Internet is a consumer media delivery system.  And yet, it’s easy to find ways to overcomplicate this simple picture.

Take for example the argument over whether The Web Is Dead. Putting aside the easiest objection – that many claims of death are exaggerated – the thesis basically says that “the Web” was supposed to be this great open playground that changed the world forever, but a variety of closed systems now threaten the promised paradise. We are supposed to get hysterical over the idea that content that was free on the Web will not be free forever, and that there will be special access channels that only some people will be able to afford.

But the Web isn’t dying, it’s just evolving the way that consumer media have always evolved.  The history of consumer media is littered with similar patterns of free and paid content, amateur and professional content, sponsored and bought content. There are many examples where a new medium was popularly established with free content, and evolved into a tiered system of both free and paid content. Look at television – once it was free (i.e. ad-supported), then cable TV came along with both an ad-subsidized paid model (basic cable) and an ad-free paid content model (e.g. HBO, PPV).

The same thing is happening with this wondrous new medium of the Internet, and the most wondrous thing of all is that anyone thought it would be any different.  The Internet is wonderful and has changed many things in the consumer content landscape, in terms of interactivity, variety, engagement, and low production and distribution costs. But one thing it hasn’t changed is that consumer media, as a whole industry, will always trend toward payment for quality content, and toward concentration of media power in the hands of a relatively small number of players.

I wish that weren’t true, but it is true today and will always be true for as long as we remain human beings.

We like to think that technology frees us from the scarcity-based economics of the past.  And it’s true that changes in scarcity can free up new business models.  But there is no kind or amount of technological advancement that can eliminate scarcity in two areas:

  • Quality. Quality content is by definition scarce: no matter how great the aggregate improvement in overall quality, there will always be some portion that is better than the rest. The development and application of new technology to content only heightens the divide, not flattens it – because the quality of the content includes not just artistic merit but its presentation and convenience to the consumer.
  • Attention. Human attention is limited, both in the aggregate and for any individual. No matter what automatic aggregation, filtering, or curation tool is ever developed, we can’t radically increase the finite amount of real human attention for consuming media. Even if we develop technology that actually stops time, our biology dictates a finite attention span – there’s only so many hours of media a brain can absorb in a day, no matter how long the day is.*

Since quality is scarce and attention is finite, there will always be an opportunity to charge money for the best content – and since this includes charging for the best quality presentation and delivery, it means that there will necessarily be a two (or more) tiered Internet. You can call it surrender, you can call it the death of the Web, you can call it whatever you want – but recognize that it’s progress, it’s evolution, it’s the future as well as the past.

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On a related (and more obscure) note, lately there’s been a lot of conversation about the evolution of certain parts of the venture capital business. I can’t do the whole conversation justice – but basically the narrative is that there is a new mode of investing in the consumer Internet sector, with smaller but smarter initial investments, giving rise to an expanding birthrate of web startups, and raising the specter of a seed investor bubble.  Again I’d ask, should we try to understand all this as a new phenomenon, or is this just a different variation of a familiar pattern?

Consider that a lot of “Consumer Internet” is no longer mostly about technology development, it is about media content development. From that perspective, a lot of the shifts in venture investing are about a certain class of savvy investors becoming media investors instead of technology investors. They’re not evolving to some kind of new model of investing, but cycling into the model of investing that you see in more mature content production businesses.

I think that consumer Internet investors will become more and more like television producers and financiers, and less like “hard” technology investors.  If that’s right, you’ll stop seeing conversation about equity vs convertible debt, and will instead see a move toward the revenue-sharing model that is common in the TV and movie industry.

Some people will regard this theory as idiotic, controversial and even demeaning (if you think being a TV producer is worse than being a VC), but for me it’s just doubling back to the basic insight that the Internet is a new platform for consumer media.  Now that the original mid-’90′s revelation has come true, you can expect that the investment economics will repeat old patterns more than they create new ones.

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* I realize that there are people who believe that in the future, technology could enhance brain function as well as create endless renewable energy – making essentially limitless time and capacity to enjoy leisure activities, including consumption of media.  Without opining on the likelihood of that future, I’d just note that it’s a future in which we are no longer human, as we understand humanity today.

betting on failure

It’s interesting to watch reaction to the news of Twitter’s financing at a $1 billion valuation.  The vast majority of commenters seem appalled (or at least cynically amused) at such a lofty valuation for a company with no meaningful revenues.

The shocked reaction misses an important point:  Everyone believes that investments in companies like Twitter are likely to fail, including the investors in Twitter.  For the most part, people who invest their money in companies like Twitter are not putting their life savings into a single company; they are investing their portfolio (or an allocation of it) into high-risk, extremely-high-return-potential companies.  For that high-risk portfolio, it could be rational to invest in companies with a 90% chance of failure, if there is sufficient return for the other 10%.

Now, there aren’t many actual portfolios that are (intentionally) structured with any allocation to a class of investment with a 90% failure rate.  But it would be completely typical if every single non-employee investor in Twitter made their investment from an allocation that has a greater-than -50% failure rate.  In other words, most Twitter investors believe that it’s likelier than not that Twitter will fail.  (Here, “failure” means that the investment will fail to reach the modeled return, not that the company will completely go out of business.)

It’s easy to say that Twitter will probably fail, but how many critics are confident that there is a less than 10% chance at a 10X return?  Investors in Twitter don’t bank on Twitter, they plan that either Twitter or one of the other companies in that allocation of their portfolio will make an outsized return.  Many of those investors have been right time and time again about their projected portfolio performance, which means that as a reward they will continue to invest in companies that are likely to fail.

unforgiven

Apparently Chris Dixon is my new blog crush, a potential successor to worthies such as Pmarca and Steve Blank.  And I’m not alone:  Venture Beat picked up on Chris’s suggestion that the 2-and-20 compensation “rule” in venture capital compensation deserves to be revisited.

But my thinking about this whole conversation is best summed up by the immortal (and surprisingly moral) William Munny:  Deserve’s got nothing to do with it.  People talk about venture capital compensation as if there is some moral justification for what they make, or conversely a moral reason why they shouldn’t make their money.

Now, I don’t belong to the amoral school of thought that says that people “deserve” whatever the market will pay them – sometimes the market is wrong, sometimes the conditions are unfair, so sometimes there are outcomes that are morally unjust.  However, this is not one of those times.

Venture capitalists negotiate their compensation terms with extremely sophisticated investors.  Those investors are willing to pay VCs an amount that still gives the investment portfolio an expected return that is correct at the time of projection.  Sometimes the investor projects incorrectly, but that’s not a moral misjudgment, it’s just people not being good and/or lucky at their jobs.  And if the VC sector underperforms expectations, compensation will get adjusted over time.  Deserve’s got nothing to do with it – this is a case where the market is perfectly capable of taking care of itself.

entrepreneurial lobbying

Warning:  this post is very long and concerns tax policy, and so is likely to suck your soul while you read.  However, if you have been or ever will be a highly successful entrepreneur, then I’m talking about matters that mean millions of dollars to you.  Enjoy.

We are in a time when the government’s hand in the U.S. economy is heavier than at any time since as least as far back the 1930′s.  Makes me wonder who, if anyone, lobbies in D.C. for the benefit of entrepreneurial activity?

The National Venture Capital Association has been in the news of late, as it tries to avoid Congressional and Treasury proposals to regulate “private pools of capital” – a generic term that includes hedge funds as well as venture capital funds.  Hedge fund activity in the credit markets may have contributed to the systemic failures in the financial system, but commentators indignantly proclaim that venture capital had nothing to do with the current mess.

The NVCA is the main lobbying organization of the venture capital industry, and in their stated mission and nearly all of their public policy positions, they say they have a broader mandate to “support entrepreneurial activity and innovation.”  The NVCA wants Washington to understand the VCs are not merely investors, but part of the lifeblood of the entrepreneurialism that fuels massive portions of the U.S. and world economy.

I suspect that at first the fine folks at the NVCA made this connection to entrepreneurialism because it sounds worthy and friendly to politicians, as compared to being cast as mere financial speculators.  But now this connection has become a key conceptual anchor of their argument that venture capital should be treated differently from hedge funds and other private equity funds.  Those other guys are pointy-headed number crunchers, see, who move massive amounts of money and credit with extreme disregard for our financial system.  VCs are closely involved with startup innovation, heck they are practically entrepreneurs themselves!

This conflation of VCs with entrepreneurs is even more critical in what has become the most important lobbying battle in the history of the NVCA, the fight over carried interest tax policy.  I think if more entrepreneurs understood this particular public policy issue, there might someday be better lobbying in DC for related issues that are closer to the hearts and wallets of entrepreneurs.

Briefly, VCs are typically compensated in two ways, with management fees and carried interest.  Management fees are a small percentage of the total capital commitment of the fund.  For example, a $100 million fund might have a 2% management fee, so the VCs receive $2 million per year for their operating expenses.  Carried interest is basically profit sharing on the investment.  So for example, if the $100 million fund operates for 10 years, and makes $500 million, a 20% carried interest might be applied on the profit – that would be $500 million less the $100 million of invested capital, less the $20 million of management fees (assuming 2% per year).  So 20% of $380 million is $76 million.  I’ve smoothed over a lot of variations and complexities, but this is basically how it works.

And how the U.S. tax system works – smoothing over a thousand times more variations and complexities – is that you either pay ordinary income tax of 35%, or long term capital gains tax of 15%.  Have you guessed what the carried interest tax policy battle is about?  That’s right:  carried interest has historically been taxed as capital gain, but many are now calling for it to be taxed as ordinary income.  In the example above (which would not be a particularly large or extraordinarily successful fund), the 20% difference in tax rates would mean $15.2 million less for the fund managers.  You can see why this is the Battle of the Century for the NVCA.

Now, let’s get back to this point about VCs being practically entreprenuers themselves.  In Congressional testimony, the NVCA says that venture capitalists rise above mere “financial engineers” (presumably the hedge funds and private equity guys), contributing sometimes daily management attention and real “sweat equity” into startup companies.  Some entrepreneurs may snicker at that testimony, and others may pluck their eyeballs out rather than read it.  I can freely admit that I’ve seen VCs who do make invaluable contributions to their portfolio companies, far above merely providing money.

But if the NVCA really wants entrepreneurs to view their efforts to “support entrepreneurial activity” favorably, they ought to extend their views on tax policy to the issues that really and directly affect entrepreneurs.  See, although startup founders can readily enjoy capital gains treatment on the value of their equity, some bizarre tax policies in this country often have the practical effect of forcing ordinary income treatment on the equity stakes of many private company employees.  The NVCA is fighting tooth and nail so that VCs (who are almost like entrepreneurs, after all) can get capital gains tax treatment, while saying not a single word about the policies that cause millions of startup employees to have their equity gains treated as ordinary income.

There are many ways that the NVCA could advocate tax policy for the benefit of entrepreneurs, but I’ll note the two most obvious ones, one a layup and the other a long ball in difficulty of change:

The layup is the Section 83(b) issue.  This is just an utterly bizarre policy that is harmless to entrepreneurs if you file all your paperwork correctly, but it is ruinous to entrepreneurs (and often their companies and lawyers) when there is a mistake in filing.  Briefly, founders and very early employees of startups usually receive stock (not options, but the stock itself) that is subject to vesting.  The tax code says that ordinary income tax is due as the stock vests, on the spread between the price paid for the stock and the value on the date of vesting.

That’s a real problem, because even as the stock vests, it has no liquid market – meaning that the stock can’t be sold easily.  So an entrepreneur who holds this stock in a successful company would get huge tax bills that he or she cannot pay.  Fortunately, the IRS allows the stockholder to make a “Section 83(b) election” – this is an election to pay the tax at the time of the initial stock purchase.  Since typically the price paid for the stock is the fair market value of the stock at the time of purchase, there is no spread and therefore no tax is due.

So that would be harmless, except that if you don’t file the election in the right way at the right time (30 days after purchase), you have to pay taxes the default way.  And that kind of mistake does happen, and it can cost millions – not just for the taxpayer, because ruinous tax issues for company founders and early employees can easily sink the company itself, and also typically results in malpractice suits against the company lawyers.

Why should the default position in the tax law be to pay a ruinous tax that no rational person would ever voluntarily elect to pay?  Why not just have a law that says if I don’t do a cartwheel on my lawn every 30 days, then I have to give my house to the IRS?  This is just utterly inane, so inane that it should be an easy win for the NVCA if they were to take it up as a lobbying cause.

The long ball would be for the NVCA to go after AMT/ISO reform.  This is a very complicated issue, but bear with me, because this problem does routinely affect startup company employees.  In a vast, vast oversimplication:  the problem is that the Alternative Minimum Tax requires Incentive Stock Option holders to pay a tax on exercise of their options, even though the company is private and there is no liquid market for their shares.

In a successful company, this can mean a tax vastly exceeding the assets of the employee, with no means of paying it.  A typical solution for many is to sell their shares at the mercy of the less liquid secondary markets (at severe discounts), in order to be able to pay the taxes.  And of course, a sale in that situation is typically taxed at ordinary income rates rather than capital gains rates, because of ISO tax rules.  So AMT and ISO rules conspire to mean that startup employees often are forced to sell their stock at discount values, and to add insult to injury the gain is taxed as ordinary income rather than capital gain.

So, NVCA:  you need to go after those two issues before any knowledgable person should regard you as an advocate for entrepreneurs and innovation.  Not only would you get the cosmic satisfaction of your actions actually conforming with your words, but you would also likely get grateful contributions from entrepreneurs and their lawyers.