Saturday, January 31, 2009

Time to Bring Financial Wizards Back to Earth

When you read today's Wall Street Journal about the outrage over Wall Street bonuses, there's a telling quote at the end:

"From 2002 to 2008, the five biggest Wall Street securities firms paid an estimated $190 billion in bonuses. Those companies churned out $76 billion in combined profits during the same period. Last year, the companies had a combined net loss of $25.3 billion, yet paid bonuses of roughly $26 billion."

That means securities firms would have broken even had they done what most responsible firms would do - rein in controllable expenses. When you are burning investor cash, you need to find a way to make a profit, not overpay people who are losing money for you. However, Wall Street doesn't work that way, they think they actually deserve multi-million dollar bonuses for their work. They say they work a tremendous amount of work and have specialized knowledge. Well, given the unbelievable damage they have caused the world economy, that specialized knowledge was not so valuable after all.

I know I'm going to get in trouble here as a number of my friends have made fortunes on Wall Street. I have a lot of respect for those in the investment banking and financial field, but it's about time the field gets called out for its abuses.

In one of his famous letters to shareholders, Warren Buffett discussed how financial executives were not creating value with derivatives and hedge funds as much as they were simply moving money around and taking more for themselves. First came the financial advisor, then the mutual fund manager, then the hedge fund manager. At at stage, the financial manager, would move around the same investments, continually taking more for himself. Derivatives were extreme forms of this practice as they were highly leveraged to supercharged returns with little clarity of the underlying risk.

I will acknowledge that efficiency reduces interest rates by providing greater transparency and assessment of risk. However, as an electrical engineer who used to take electives like multidimensional calculus of imaginary number for fun, even I had a hard time understanding the models. I have a feeling that these folks used complex spreadsheets that spit a decision without knowing what they were doing.

There was so much money to be made that instead of going into electrical engineering, our top minds went into financial engineering. When I heard that 1st year Harvard MBA's were going paid $350k to go into hedge funds, you knew there was a problem. Real engineers create new products and technologies that transform our lives. Financial engineers move money around - valuable - but its not like creating the next generation solar array or the Dreamliner. For a while there, people thought that becoming the financial and retail center of the world was the way to go. The last year has shown us how dangerous that is.

Financial supermarkets like Citibank and Bank of America have been widely discredited. Lehman Brothers, Merrill Lynch, and Bear Stern has shown the disaster of overleverage. AIG - that's $150 billion of taxpayer money - and still going.

Obama labelled executive bonuses as, "Outrageous!" It is my hope that this is the beginning of a new era. We will reconsider our devotion to these financial gods who create exotic ways of manufacturing money out of whole cloth.

My message to you: No, you do not deserve extraordinary compensation when you need a taxpayer bailout. You failed and must be held accountable. Saying that, "Nobody saw this coming," is a lame excuse. For years, you've been claiming millions of dollars in wealth for working for brand names while shifting money around. You've demanded accountability from the companies you invest in. It's time to take some of your own message. You too, Robert Rubin. I love your service for the Clinton administration, but you sat by at Citibank allowing the firm to use diversification to create even greater risk.

I love Sen McCaskill's new bill limiting bailout executive compensation to beneath Pres Obama's pay. That's no more than $400k in overall comp. As mentioned in my previous blog, it should be lower - like $200k. These corporations are riskless. They have the US government as a backstop. It's hard to argue that the CEO of Bank of America is worth more than the Defense Secretary. Robert Gates is responsible for America's security. Kenneth Lewis runs one of many big banks. It's a bank that needs to be broken up. One bad decision and we all pay. Maybe we should use the bailout money to seed fund the start-up of new banks. Maybe they will actually lend with reasonable underwriting standards.

John Thain is a true fraud. Earlier, he saved the NYSE, but decided to cash in at Merrill. He attempted to ensure traders and execs got bonuses while Merrill lost $15 bil in a quarter. Let's not even talk about the $1 million in furnishing his office. And who is backstopping these losses - not Bank of America - it's the United States of America.

Since Obama did not take money from corporations and PACs, he can truly lead a change of culture. Move away from crony capitalism where the richer can lobby and pay their way to get richer. Move to a culture where real innovation is rewarded and excessive pay is diminished. Rather than putting limit on compensation, bring back high marginal tax rates. For income over $1 mil/year bring back the 50% marginal tax rate. You made that money because the US system gave you an advantage. There are soldiers around the world protecting your ability to make wealth. Your access to government officials enable you to get special tax and business breaks. You have a legal framework to ensure that contracts are actually enforced. It's your responsibility to pay for the system that provides you that benefit. I'm not talking about capital gains on a startup - those investors and management create real value without government officials bailing them out. I'm talking about the proponents of the supposed death tax.

The free ride is over - it's time to change.

Tuesday, January 27, 2009

Update to the Position2 Team

In the spirit of openness, I wanted to share an email I sent to the Position2 team. It's been edited a little to protect confidentiality and add context. Given the market uncertainty, I wanted my team to understand my thoughts. We have realigned our focus and have made cuts. And the same time we are adding business and people. Sound confusing? Well, read on.

Position2 Team,
Many of you heard from your manager about the recent changes at Position2. I wanted to update you on what is occurring in the company, especially in terms of what we see in the market.

The Market Storm
Everywhere you read, everywhere you look, the news is ugly. Banks in trouble, companies laying off or slashing payrolls, consumers not buying, foreclosures up, venerable auto and retail firms at risk of bankruptcy or liquidation. It does not matter if it’s in the US, Europe, India, Russia or the Bahamas – it’s everywhere. The global economy has not diversified risks. It has only magnified them. It used to be fun every morning to read the Wall Street Journal. Now, I read a book about something else as every news article is a rehash the same thing. We discussed this when I was in Bangalore. It has definitely impacted Silicon Valley. Companies are not getting funded. Many are just being cut off by their backers. You can go to my blog to read about a personal saga of an entrepreneur I know well. There are storms and there are storms. This one is one of those once every century ones.

Impact on Us
Our market is impacted. Online ad spend has been projected to slow its growth, however the reality has been quite different. Even those who have successful campaigns have cut back (with some notable exceptions). The constant stream of bad news has caused businesses to pause and cut back in one of the easiest (though not smartest) places – marketing and vendors. We have been in various talks with firms looking to break their arrangement with us. Luckily, our agreements were well written enough and performance strong enough to provide a strong defense and favorable resolution. Many of the deals we were going after either slowed or stopped decision-making altogether. We are not out of the woods completely, but it is stabilizing. We do have a strong client base that is mixed across a variety of industries, because of our performance, there are growth opportunities with them especially as the market stabilizes.

Aligning our Cost Base
In this market with limited funding opportunities and uncertainties in the market, we needed to be solidly in cash flow positive. To get there we have instituted an x% pay cut with a new bonus program. In this program, for every cash flow positive quarter our team will receive y% of the net positive cash flow in a proportionate manner. This will be paid on a quarterly basis and replaces all other bonus programs. While many companies have simply cut at greater levels, we believe that this will allow us the ability to work together to not only earn back our pay, but exceed it.

We have also realigned our sales and marketing effort. The team is a little leaner, but more effective. Our team has identified and are pursuing a number of significant opportunities.

These moves keep us solidly in cash flow positive territory. This is a shift from our previous focus on faster growth through direct clients. That does not mean will not hire or spend money – we definitely will. We need certain hires to support client or company development initiatives. We need to improve our infrastructure to increase productivity and communications internally and externally. It simply means we all need to be careful about how we spend our money and aligns all of our collective interests.

Future Outlook – We Will Flourish
Because of our cost base and our diversification, we have excellent prospects for the future. With a strong investor in Accel, we are getting excellent leads. We continue to market across our network. Given our search and social media marketing experience and company infrastructure, we are focusing more strongly towards agencies. In the past, many of the agencies we worked with too small and unsophisticated about this space. Now, we are reaching larger players who know this space, have hiring freezes and margin pressure. Recently we closed major internet brand for search marketing services. We also closed on a major project with a significant search marketing agency. We are also engaged with other large agency players. Online advertising and marketing services is a relationship-based sale. You cannot simply advertise reputation, features and prices as in traditional marketing, people need to know you. It’s our job to enhance that through programs that help people understand who we are and how we think. That’s where Position2 marketing comes in – we all need to be engaged in it: blogging, social networking, speaking at conferences, participating in industry forums, etc. One person can’t do it all, we all have to help.

The best news now is the US has a President who has broad support the world. The best thing Obama can do is instill confidence in the future, so that decisions can finally be made. There are some signs of a turn in a stabilizing stock market, increases in home sales and a large worldwide stimulus package. I personally have raised money during the 2000 tech bust and have seen recessions where US unemployment, interest rates and inflation were at double digits - even worse than today. Just as oil prices could not go up linearly forever, nor will people and businesses continue to withhold purchasing and stop innovation. Great companies were started in previous downturns – GE, Cisco, Microsoft, HP and Disney. There's no reason to believe that this recession will be different

We certainly can flourish – and we will.

Go Position2!

-Rajiv