Burnham's Beat

Internet Stock Update: July 2005

Internet Stocks were up a strong 7.0% in July vs. the NASDAQ's 6.2% overall rise.  Amazon led the entire group, up a very strong 36.4% on strong Q2 earnings and an improved outlook.  Ebay also had a very strong month up 26.6% as its strong Q2 earning relived some worries that Google and high fees were hurting it's business.  The average stock was only up 4.7% indicating that large cap Internet stocks did particularly well.

There were no Internet IPOs in July, one of the few recent months without Internet IPO activity.

For a detailed breakdown of all the stock statistics including a record of all of the M&A in the space, click here to download an Excel spreadsheet with the data and click here to get Microsoft's automatic stock quote downloading plug-in for Excel if you don't already have it.

Software Stock Update: July 05

The Software Stock Index was up a relatively weak 4.4% in June compared to the NASDAQ's 6.2% overall gain.  The average stock was actually up 6.1% indicating the small caps had a much better month than big caps.  This month's best performning sectors were Business Intelligence (20.7%) thanks to strong Q2 earnings especially from Microstrategy and Applix, Operating Systems (13.6%) thanks to a mild recovery at RedHat, and Healthcare Applications (9.9%).  The worst performing sectors were Wireless Applications (-5.3%) thanks almost exclusively to Infospace's implosion, and Operations Management (+4.1%) thanks to a weak month for  Motive and Intraware  which both gave up almost all of some strong gains they had in June.

For a detailed breakdown of all the stock statistics including a record of all of the M&A in the space, click to here download an Excel spreadsheet with the data and click here to get Microsoft's automatic stock quote downloading plug-in for Excel if you don't already have it.

MySpace Equals Mo’Money For VCs, Especially VantagePoint

You may have seen the news today that Intermix Media was sold to News Corp. for a cool $580M in cash.  Prior to 2004, Intermix’s business consisted of running a collection of largely undistinguished consumer-oriented websites.  Intermix (then known as EUniverse) didn’t do a particularly good job of running these sites and was basically a broken stock suffering from earnings restatements, a NASDAQ delisting and executive turnover.  However in 2003/2004, one of the websites, MySpace.com started to take-off thanks to the social networking craze.

As I outlined earlier, unlike Friendster and its clones, MySpace took a unique approach to the Social Networking space and concentrated heavily on building a community first (centered around music and bands), and a social network second.  The strategy worked and by the beginning of 2005 MySpace was the clear #1 player in the social networking space.

A VC Social Networking Payday …  Finally
Well today, MySpace and its VCs were richly rewarded for their success when News Corp plunked down a substantial wad of cash for Intermix.  Although Intermix owns other websites, it’s clear that News Corp. paid the high price mainly to get control of MySpace.

For VCs, this sale is significant because it represents the first real payday in the social networking space, a space that to date has seen lots of VC hype but very little returns.  Just how big a payday was it for VC’s?  Thanks to the fact that Intermix was a public company it’s possible to take very educated guesses at how the VCs made out.  There were two main VCs involved in MySpace/Intermix.  VantagePoint had been involved with the parent company for some time, while Redpoint recently invested in MySpace itself.

RedPoint: Rapid Happiness With a Tinge of Regret
In terms of Redpoint, according the latest 10-K on file, they made two investments, one in Intermix in 12/04 and one in just MySpace as a separate entity in 2/05.  The Intermix investment was $4M and it got Redpoint 1M common shares and another 150,000 warrants at $4/share.  At $12/share that would net them $13.2M on a $4M investment or a 3.3X return.  They invested a separate $11.5M in MySpace itself which got them a 25% stake (which equates to pre-money valuation of $34.5M) in MySpace.  Unfortunately for Redpoint, when they made their investment in MySpace Intermix got them to agree to a provision that Intermix could buy back all the shares of MySpace that it didn’t own at a fixed valuation of $125M if Intermix got a buy-out offer within 12 months of the investment.  That is precisely what happened and according to news reports Intermix is exercising its option to repurchase the shares.  What this means for Redpoint is that their 25% stake in MySpace (which arguably represents almost all the value in Intermix) will not be worth 25% of $580M ($145M) but rather 25% of $125M or $31.25.  That said, this still represents a 2.7X return on their investment in MySpace.  Taking its two investments together, Redpoint looks like it will take home $44.45M on $15.5M invested or a 2.9X return. If the deal closes in 3 months this should equate to an IRR of roughly 325%.  Despite, missing out on the bigger payday because of the repurchase option, this has to be viewed as a great success for Redpoint, especially because they did the deal right under the nose of VantagePoint and clearly spent a lot of time structuring and selling their way into a deal that on first blush would have looked to be too difficult to put together at all.

VantagePoint: One Man’s Loss Gain Is Another Man’s Gain
For VantagePoint, the sale of Intermix was no doubt a very welcome event as according to the latest proxy statement they own 11.56M common shares (on a converted basis) worth $139M at $12/share.  VantagePoint acquired these shares in two major transactions.  The first transaction was a  rather straightforward purchase of $8M in Series C stock on 10/31/03.

The second investment happened July 2003 and it is less straightforward, but much more interesting.  In that investment, VantagePoint purchased an option to buy all of the shares owned by Sony’s now defunct VC Group, 550 Digital Media Ventures.  They partially exercised that option in October 2003 and then they fully exercised it in April 2004.  What’s most interesting about this transaction is that under the original terms of the option, Sony was entitled to some of the profits on any of the shares that VantagePoint purchased.  However when VantagePoint exercised the remainder of its option in April 2004, they also agreed to buy a $2.5M note that Sony held for just $1.8M (handing Sony a $600K loss) provided that Sony gave up its right to a share of the profits on the shares covered by the options.  This proved to be an incredibly canny move by VantagePoint especially given the fact that MySpace was growing like a weed in April 04 and the whole social networking space was white hot.  Somebody at Sony was clearly asleep at the switch.

The icing on the cake for VantagePoint is that they didn’t even end up risking their own capital on to buy the Sony note, they simply assigned the right to Intermix, who promptly bought the note for $1.8M and realized a $600K gain.  So VantagePoint not only got to extinguish Sony’s profit sharing rights for “free”, but they got to hand a public company (which they owned close to 30% of) a gift of $600K. 

But that’s not the only canny move by VantagePoint.  Indeed the sale to News Corp is very smart move for them because if Intermix had waited another 7 months, then it would have presumably had to pay Redpoint and the other MySpace investors a much higher premium for their shares.  So by selling out “early” to News Corp, VantagePoint ended up getting a bigger share of the profits than it might have gotten otherwise.

In terms of an overall return for VantagePoint, according to this Form 4 VantagePoint’s option allowed them to acquire Sony’s shares at $1.10/share, so this means that the Sony shares cost them roughly $5.3M.  Add to that the $8M in Series C shares and the $2M in debt that was later converted to shares and you have a total investment of $15.3M and at $12/share a total return of $139M or 9.1X invested capital.  Assuming the deal closes in 3 months, the IRR would be around 223%.  This doesn’t include the cost of the option on the Sony shares, but I can’t imagine it cost them more than $500K, so it’s probably not that big a deal in the grand scheme of things, who knows maybe they even got it for free.

Between making a gutsy call to invest in a broken deal, the beautiful Sony option deal, the canny timing of the ultimate sale, and, of course, the very impressive returns, the VantagePoint partners on the deal, which look to be David Carlick and Andy Sheehan, deserve a great big “gold star” for VC deal engineering and investing.  Bravo!

UPDATE:

I talked with a reporter who had a conversation with Geoff Yang, who did the MySpace deal for Redpoint.  Apparently Geoff said that Repoint will ultimately net about 50% more ($65M+) than the $44.25M I estimated thanks to the some special provisions they negotiated for their MySpace preferred stock.  Just guessing, but it sounds to me like they were able to get what VC's call a "double participating preferred", which means you get 2X your money back before everyone else and then still get your cut of what's left.   An alternative could be that they simply negotiated with Intermix to get a better deal.  Either way, it looks like Redpoint got an even better deal than I first estimated which makes their performance on MySpace all the more impressive.  Congrats Geoff!

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

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

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

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

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

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

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

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

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

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

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

AON: Why the IBM and Cisco Relationship Is Headed For A Break-Up

Cisco’s long awaited announcement of its Applications Oriented Networking (AON) products a couple weeks ago foreshadows a coming battle that may rip apart the cozy and long standing strategic alliance between IBM and Cisco.  Cisco and IBM have somehow defied the odds over the last few years to maintain a high-profile strategic alliance, one which many people felt would be over faster than Britney Spears' 1st marriage.  The two companies have partnered together on a myriad of initiatives from data center management, to security, to storage networking, seemingly secure in the knowledge that neither firm had any intentions of getting into the other’s core business.  However with the launch of AON it is now crystal clear that Cisco has designs on at least a portion of IBM’s core business and that IBM must respond before one of its crown jewels, its infrastructure software portfolio, is rapidly commoditized.

E Tu, Taf?
The primary architect of Cisco’s new AON strategy, Taf Anthias, is none other than the former head of IBM’s MQ Series middleware messaging platform.  What Taf has done at Cisco is to try and create networking devices that are not packet aware, but message aware.  As I have outlined before, message aware networking is one of the most important trends in software today.  The focus of message aware networking is to migrate basic tasks such as security, transformation, and message routing away from application servers and message brokers and into network devices.  This migration should not only theoretically increase performance and enhance flexibility but it should also create the foundation necessary to properly run complex, highly scaled, Service Oriented Architectures.

Same Problem, Different Perspective
The problem for networking companies, such as Cisco, has been that message aware networking is not a natural fit.  While it looks a lot like networking in that it needs dedicated devices to process a large volume of standards based information quickly, it also looks a lot like application software in that it is message, not packet, based, and you therefore need to understand the context and content of the message in order to be able to process it.  Cisco recognized this conundrum some time ago and instead of trying to turn some of its “packet heads” into application engineers, it hired Taf.

Infrastructure software vendors, such as IBM, face the reverse problem: message aware networking looks a lot like middleware message processing, but it requires a level of performance, security, flexibility and even dedicated hardware that makes it look a lot more like networking.

An Uneasy Truce Leads To A Long War
For the last couple years, both the networking companies and the infrastructure software companies have recognized message aware networking as a dangerous, but potentially lucrative “demilitarized zone” that separated their two industries.  Up until now, both sides have been content to let a small cadre of start-ups fight it out as none of the big boys wanted to risk upsetting the global order by making a major move into the space.

However with the explosion of interest in Service Oriented Architectures and the rapid adoption of XML-based messaging, it was only a matter of time before one of the big players made a move.   Now that Cisco has taken the first shot with AON,  IBM, and other infrastructure software players such as BEA, HP, CA, and Microsoft, must respond or they risk ceding a significant portion of their “value add” to Cisco and other networking vendors.

While there are many battles left to fight in the war for control over message aware networking, the first casualty will likely be the previously cozy relationship between IBM and Cisco as it's hard to partner with someone that has clearly made a strategic decision to try to destroy part of your core business.

Software Stocks Update: June 2005

The Software Stock Index was off 2.3% in June compared to the NASDAQ's 0.5% loss.  The average stock was actually up 0.9% indicating the small caps outperformed big caps.  This month's worst performning sectors were Digital Media (-13.8%) thanks to weakness at Adobe, Development Tools (-15.1%) thanks to weakness at Macromedia and Mercury Interactive, and Security (-6.9%) mostly due to Verisgn and Checkpoint .  The best performing sectors were Asset Mangement (+5.3%) thanks to a big month for Datastream, Financial Services (+4.4%) thanks a Ameritrade's takeover dance and Operations Management (+4.1%) thanks to strong months for Motive and Intraware .  For all of Q2, Software stocks were down 2.0% compared to the NASDAQ's gain of 2.9% so software stocks had a pretty bad quarter relative to the rest of the technology market.

For a detailed breakdown of all the stock statistics including a record of all of the M&A in the space, click to here download an Excel spreadsheet with the data and click here to get Microsoft's automatic stock quote downloading plug-in for Excel if you don't already have it.

UPDATE: Just How Much Did VCs pocket on Google?

A few days ago I did a post that looked at the public filings on Google and did some calculations on just how much the VCs involved in Google made on their investment.  One of the calculations I made was an attempt to deduce what the personal carried interest of the VCs involved (John Doerr and Mike Moritz) by looking at the distributions they received as reported on their SEC Form 4s.

I recently talked with some folks who definitely know many of the actual numbers involved and they pointed out to me what in hindsight is a rather embarrassingly obvious fact: that the distributions received by individual partners include both carried interest as well as the proceeds from any personal investments made by the partners themselves into their fund, something which I had, quite stupidly, not figured into my deductions.  In many venture funds, these investments are usually quite small, somewhere between 1-2%, however in some funds partners make very significant personal investments and it's likely that both of the partners involved in Google had substantial personal investments in their own funds.

Based on this, I have no doubt now that the 40% share of profits that I deduced for John Doerr at Kleiner is wrong and that the 21.5% share I deduced for Mike Moritz is probably wrong as well.  Both of their carried interest shares are lower and in the case of Doerr, significantly lower than the 40% number I deduced.  While the absolute # of shares that have been distributed to them is still correct, there's no way to figure out what portion of those shares were for their carried interest in the fund and what portion were for their own personal investments in the fund without more information, so it's impossible to estimate their specific carried interests without that information and therefore it was in many ways irresponsible of me to even hazard a guess.

As I said in my original post, both VCs deserved every penny they earned and now that it's clear a fair number of those pennies came from the partner's personal money they put at risk and invested into the fund I have to say that I think they deserved their rewards even more that I though at first.

Internet Stock Update: June 2005

Internet Stocks had a relatively poor June thanks largely to poor performance from several large cap names, especially Yahoo and EBay.  Overall, the internet sector was down 4.2% although the average stock was up 4.2% indicating strong performance by small caps.

Two new Internet companies went public this month, both in London.  The first was Party Gaming, the parent of the largest online poker site, Party Poker.  With a $10BN+ market cap it is now the 8th most valuable internet stock on the planet.  The other IPO was FireOne Group, the parent of online payments company, Firepay, which just so happens to get much of its revenues from clients tranferring funds into and out of (but mostly into) online poker rooms.   There are now 4 online gambling related companies trading in London including PartyGaming, SportingBet, Neteller, and Fireone and there will probably be at least a few more by the end of the year.   I have been long SportingBet and Neteller for some time in my "virutal stock portfolio", and I continue to think that the online gambling stocks have real legs.

For a detailed breakdown of all the stock statistics including a record of all of the M&A in the space, click here click to download an Excel spreadsheet with the data and click here to get Microsoft's automatic stock quote downloading plug-in for Excel if you don't already have it.