In this penultimate week of my finance class, we had a guest venture capitalist come to do a case study with us. The class aimed to highlight the basics of venture capital in comparison with private equity (which we studied previously). Below are the top ten takeaways from the class, which was really engaging and interesting.

1. The most important factors VCs consider in a company are market size, management, and competitive advantage/product. The fastest way to understand market size is through calling customers; a few phone calls (primary research) will go much further than looking up aggregated, often useless stats in a database.To understand competitive advantage, look at technology and financial statements. In terms of financial statements, premium gross margins (45%+ as opposed to typical 20%) can often point to competitive advantage.
   
   
2. The actual product and technology are more important than past financial statements. Past financials, in the VC/early stage world, are irrelevant and almost always not predictive of the future. VCs care about growth and future profitability, not past financial results. Past business development/growth/management goal-attainment results are another story, though; those matter a lot. VCs invest in uncertain businesses where the future will not be like the past; private equity (PE) invests in firms where financial statement analysis is critical because businesses are more stable.
   
   
3. Time can be an advantage for the investor when it eliminates competition for the deal. If a VC has a small window of opportunity to see a deal first and have some exclusivity to it, this is a rare opportunity that he or she will try to take advantage of. On the flip side, many VCs like to invest together (social proof), so this has its risks as well.
   
   Often times, VCs can use tight deal timing and uncertain financial statement reliability to their advantage. If the company is in a rush to close a deal and/or has financials that are not really reliable, this can help in negotiating a better price for the VC. In VC, the outcome is more important than the decision-making procedure because time is of the essence for capturing opportunity. The guest also told us that he typically knows within 15 minutes of meeting an entrepreneur whether he wants to make the deal.
   
   In terms of price in such circumstances, it only needs to be justifiable to the board (and the VC fund) and show reasonable analysis; it is not the result of some careful projections or analysis. Prices are determined by gut and then vetted out through some bounds analysis and taking a look at comparables. Therefore, VCs aim to negotiate for the lowest possible price that is justifiable somehow by comps and rough projections.
   
   
4. Venture capital is about being a home run hitter. It's all about hitting home runs once in a while and losing on most other deals. You won’t be fired for taking risks, but you will be fired for missing opportunities.
   
   In this way, it's all about maximizing the likelihood you get lucky by investing in companies that have any hope of getting huge. VC thus is an art that is about seeing big ideas and getting on the deals with the highest potential. PE is much more of a science than VC because there the companies are typically more established and will likely continue in the same way as they have in the past.
   
   
5. Venture capital is about relationships. The guest spoke of investing in a company as analogous to being married to the entrepreneur. The way that VC firms differentiate from others is through their connections and networks.
   
   Our professor chimed in to add that from whom you get the money is more important than getting the money and on what terms.
   
   
6. During acquisitions, you need to always consider what will happen if you don’t acquire a company that will be sold to someone anyways. Often times, just by thinking about the alternative, it's clear that making an acquisition is the correct strategic decision for a company. An example is a car dealership that can buy a nearby location; it would clearly prefer to have that location rather than be hurt by additional nearby new competition.
   
   
7. The number of VC deals is roughly stable over time; what changes given market conditions are price and terms. We looked at graphs of deal flow over time, including number of deals, capital deployed, and average deal size. There were clearly swings over the past 10 years, but looking at a longer time horizon, the trend is stable.
   
   Our guest explained that the number one determinant of whether our economy will grow at 3%+ per year (to sustain job growth, etc.) is the number of $1 billion+ revenue businesses started per year. Based on this and the above, he assured us that good ideas and people will always find capital available.
   
   
8. Great entrepreneurs will find attractive markets; trust the person more than the specific market. Smart people can adapt to changes in the market and are required to execute on business ideas, even ideas that are inherently poor or at a disadvantage. On the flip side, a great idea can easily be mis-executed or an opportunity missed by a suboptimal entrepreneur. Our guest believed that the biggest reason for failure among the deals that failed on him was management (the team not working well and not hiring fast and well enough).
   
   
9. Structuring a VC deal portfolio involves many trade-offs. When we asked about investing in one narrow space or industry versus achieving diversification, our guest explained that there is a trade-off between diversification and specialization in the field you know. You want to invest where you're experienced and familiar, but you also don't want to put all your eggs in one basket. However, if a particular market niche is really big, you want diversification within that and can have as many bets in play as possible. For example, many of the most successful investors in social networks early on invested in all of them instead of trying to predict which would succeed. As long as Facebook was in that portfolio, it couldn't be a loser in the end.
   
   
10. Evaluating exit offers is about weighing the risk of future execution versus the potential of huge outcome. We talked about the acquisition offers our guest's portfolio companies had received over time and the way they decided which to accept or not. It all boiled down to how big of an opportunity they thought they could capture; in many instances, one bird in the hand (accepting the acquisition) was turned down for two in the bush (potential huge growth) based on the traction and momentum of the business at the time and the projections of the size of the opportunity. This is obviously a guessing game, and one just needs to trust one's gut in making the decision.
    

I thoroughly enjoyed the class, even though the basic concepts weren't new to me. It was nice to just hear about the guest's stories and perspective that tied together many strategic concepts about VC investing that I had learned about before.

One of my favorite classes this quarter is real estate investment. It's taught by a professor who runs real estate investment funds and is quite active in the industry. His enthusiasm and real-world anecdotes make the class really interesting and insightful.

I've tried to capture the biggest lessons I've learned in the class so far below.

1. The 5 P's of real estate analysis: This is a great framework through which any deal can be analyzed.
   
   People: Who is involved in the deal and what are their motivations? This obviously includes the buyer, seller, brokers, syndicate participants, mortgage financiers, developers, managers, and many other parties. Often, the people involved and their motivations are more important and influential than the project and its economics.
   
   Process: How was the property found, built, developed, negotiated, analyzed, researched, etc.? The class taught me that, due to many factors including the gross inefficiencies in the real estate market, primary research is what drives competitive advantage in real estate investing. Primary research includes thorough property visits, mystery shopping the comps (or comparable properties nearby), speaking to tenants and managers directly, pulling public records at city hall, and not relying on secondary materials (especially from brokers) for anything important. With brokers specifically, there could be many conflicts of interest in dual agency relationships in states that permit them (like CA), where the broker represents both sides and is unlikely to do all the due diligence you really need to make a wise decision.
   
   Project: What is the property involved (location, size, asset class, etc.)? This is a micro-market view of the investment.
   
   Panorama: What is the overall broader market doing where this property is located (demographics, unemployment, interest rates, credit availability, etc.)? This is a macro-market view of the investment.
   
   Projections: Here is where the numbers play in, and the class was very focused on making adequate, thorough projections of an investment's economic performance (specifically, NOI, or net operating income, equivalent to cash from operations). Useful analyses included sources and uses of capital, return on investment, and most importantly, sensitivity analysis of the projections to the largest drivers of value (rental rates, occupancy, cap rate, discount rate, etc.).
   
   
2. Real estate is all about negotiation: Very little in a real estate deal is efficient or governed by some pre-defined marketplace or law. It's all about what you can negotiate from the various parties involved and how you play the game. I was shocked to hear about the prevalence of re-trading, or renegotiating deals after they were somewhat agreed upon, and the importance of calling people's bluffs (like brokers') when they try to take advantage of you. The professor explained how the identity of the first drafter of a contract often determines who has the bargaining power (sort of like the concept of psychological anchoring), and this is something I'll keep in mind when analyzing future negotiations situations.
   
   
3. Taxes are critical to any real estate deal: There are many levels of taxes that operate on an investment (property taxes, ordinary income taxes, capital gains taxes, depreciation recapture, etc.). Deductions for mortgage interest and depreciation are some of the most important drivers of value in a deal. In many investment contexts outside of real estate, taxes can be a second level of analysis, but in real estate, they need to be in the model from the start.
   
   
4. Unsexy property segments can be good deals: Many people overlook deals in industrial properties and certain hotels and commercial properties because they aren't in the best areas or aren't nice looking buildings or operations. Sometimes those unmaintained and mis-operated properties are the best opportunities for turnarounds, capital improvements, and rent increases that can create large value which many might not look to do. One thing to check on though for such properties (and all in general) are environmental issues (through specialized studies and inspections) that could create large costs down the line if unattended to.
   
   
5. Deals with hair require more intricate modeling and more acceptance of risk: Few deals are straightforward and with minimal quirk; more often are deals with lots of "hair," or complications, like market dislocations, leasing issues, strange vacancy situations, and generally unstabilized cash flows. Having one large tenant as opposed to many tenants is an example of a non-standard situation that creates additional risk. Each of these quirks needs to be understood and analyzed and stabilized in some way to be able to value a property with hair.
   
   
6. Syndications offer the opportunity for average investors to enter the real estate market: By pooling together several participants' money, a real estate syndicate can make a larger overall investment and purchase a property that may not be available to any one investor. If this is done carefully and with a clear plan, it can often create a lot of value and provide a positive educational opportunity for people looking to learn about real estate investing firsthand.
   
   
7. Cost segregation is an important tool for tax efficiency: When buying a property, the buyer has some flexibility in allocating the purchase price between personal property, building, and land. There are clear definitions for each category, but many times people do not optimize this allocation. Personal property has the best tax treatment for depreciation, so increasing its allocation to the maximum extent reasonable can save a lot of taxes. There are specialized consultants who help real estate investors do just that.
   
   
8. When pensions invest, they are following a herd mentality: Usually, pensions are late to the game in most investment opportunities (based on research we looked at), so when they invest, it might actually be a good contrarian indicator (time to get out). In terms of what pensions could invest in, they are tax-free investors and would prefer investments that match the duration of their pension obligations and are generally diversified and conservative with a focus on cash flows over capital appreciation. Land and hotels are the most risky asset classes and probably least suitable for pensions.
   
   
9. Constant improvement is essential to maintaining and enhancing a property's position in the market: When owning a building, many managers or owners think their job is just collecting rents; a lot more value can be obtained by working to constantly improve the amenities and looks of the property, finding new ways to meet tenants' needs and ways to attract more demand to the property from prospective lessees. We went over a lot of neat, non-intuitive little services that a building can offer which don't cost a lot but can make a big difference in people's perceptions. A guest speaker taught us to never rent the same apartment twice; always find ways to make capital improvements in between tenants so that the building is constantly getting better.
   
   
10. Management company relations need to be handled with care: It's best to manage a property yourself or have people you really trust doing it. As with any principal-agent situation, management is often not incentivized to care about the bottom line and may even hurt the bottom line just to maximize gross revenues or whatever base it is compensated on. Generally, management companies aim to minimize their own work as much as possible and only by doing surprise visits and careful tracking can an owner know how they're really performing. Since management companies are also in charge of leasing often, they rarely realize how much of that leasing function is actually marketing and basic sales techniques; in most places, leasing practices are extremely suboptimal, which presents opportunities for those who want to do it right.
    
    
11. Utilities are not a fixed cost: This came as a surprise to me and a lot of the class, and it was very interesting to learn about several techniques that can cut utilities costs, whether through technological improvements or through legal inefficiencies and local programs where costs can be renegotiated or restructured with the city. Utilities can be a large line item which is normally taken as a given but which actually can be in your control.
    
    
12. Real estate deals are structured to create value and maximize other people's money: Often, employing clever structures with multiple classes of investors can allocate profit splits differently and allow access to alternative sources of capital that have different risk/reward requirements. By having several classes of debt and equity, different participants can get slightly different risk/reward profiles that match what they're looking for. In this way, the investment sponsor can maximize the use of other people's money and positively leverage the returns of the deal. In doing so, though, it's important that key members of the sponsor and of each important property stakeholder have sufficient skin in the game (or money at risk) so they care about the outcome of the venture.
    
    
13. Building up equity is a myth: Investing in real estate is not a guaranteed ticket to growing your savings and making money in the long run (especially as evidenced by the last few years). The key with this myth is that it ignores the opportunity cost of money (that one can't earn the same return elsewhere). With mortgage rates so low now, we should be able to earn more than this low interest rate through other investments (such as in our own businesses or professions). Yes, mortgage interest deductions (as long as they last in the future) do help make owning real estate more attractive, but just building equity in a property is not sufficient reason to make the investment.
    
    

Though my personal experience with real estate investing is extremely limited, I look forward to learning more about the asset class in the future and maybe even making my own investments sometime down the line.

As I mentioned in prior posts, I had a great time at an Anderson event last month where Tony Hsieh, CEO of Zappos, spoke to us as part of his Delivering Happiness book tour. I wondered why a big blue bus ("blue's the new yellow") was parked in front of UCLA, and I quickly learned about Hsieh's Happiness Tour during his talk.

He had written his book as a way to teach about Zappos' culture and mission of generally delivering happiness. It sounds hokey, and he acknowledged it, but his passion and belief in the importance of corporate culture was infectious (infectious enough to make me buy a signed copy of his book that night which I can't wait to read).

Tony's basic message was that corporate culture is everything in determining a company's success, not just a side element that's relegated to the HR department and which determines how much people like working there. He claimed that companies that have superior, more intact, and concretely defined cultures will almost always outperform those without. He explained that they hire and fire putting culture at an equal level as skill and work ethic and will fire talented employees if they don't fit into the culture.

He also encouraged the audience to request a free copy of Zappos' culture book, which is an annual collection of their employees' testaments to and personal experiences of the corporate culture. In addition, he offered us a free download of the audiobook Tribal Leadership, which backs up many of the lessons Tony was teaching that night with research studies.

I greatly enjoyed listening to the audio book over the last few weeks in my car (way more productive than listening to music, though I did intersperse some music here and there -- the radio is so much better if not listened to every day). I liked how the authors of the book compared companies at different stages of "tribal leadership" or corporate culture and showed through many vivid examples how companies can move from one stage to another.

The authors described 5 core stages of tribal leadership, where a tribe is a group of 2 to 120 people (but could grow beyond that) who align around some common goal or interest:

1. Stage 1: "Life sucks." People are pessimistic about life overall and see no way out of their misery. They are prone to crime and stealing and stop caring about any higher values. This represents about 3% of companies.
2. Stage 2: "My life sucks, but their lives don't." People think their lives suck but see others whose lives suck less than theirs. They may play tricks or be envious of others and generally do not have a lot of fun, but they do see a ray of light that they can at least try to work towards (in between feeling self-pity and remorse). This represents about 15% of companies.
3. Stage 3: "I'm great, but they're not." People work to improve themselves, see their talents, and aim to get ahead of others. This is the culture taught by schools and almost all business self-help books, teaching skills and aids and trying to help you become better than the person you are today so that you can get ahead and reach your goals (which others therefore can't reach). It is by definition a competitive culture, and one that focuses on individualistic results. It is made up of dyads, or two-person relationships, where two people can work together but contrast their skills and aim get ahead of each other. This represents about 70% of companies.
4. Stage 4: "We're great, but they're not." People work to fulfill a common, jointly agreed upon goal, and focus on group success rather than individual contribution. Olympic teams, top-performing team athletes, companies like Zappos and Amgen which are defined by their collegial corporate culture are examples. Here, the group aligns behind a common goal and a common enemy or competition. People work in tryads, networking between dyads and creating webs of support and insight that fuel growth much faster than simple dyads or individual contributors. This represents about 10% of companies.
5. Stage 5: "Life is great." People are happily working on goals that they believe in jointly without reference to other companies or competitors and simply because of their belief and optimism. This stage is often achieved fleetingly, held onto for short periods of time before coming back into Stage 4. Here, the growth rate is the fastest, with the most synergies, openness between people, and general positive attitude and happiness. This represents about 2% of companies.

(I sort of had to fudge the percentages above because I didn't remember them exactly, but those are approximately what the authors claimed from having researched thousands of companies.) I really liked this frame of mind, and I could see myself squarely as a Stage 3 operator most of the time (like most type A/overachieving personalities). I've felt what Stage 4 feels like at times, and I want to be involved in teams that can be operating at Stage 4 more often.

The book also describes the "epiphany" that brings one from Stage 3 to Stage 4: realizing that meaningful results cannot be achieved alone or through micro-management, and it is through teamwork and leveraging other people that large impact can be made.

I'd love to speak to people firsthand (other than Tony and Tribal Leadership's authors) about personal experiences of the different stages and what worked for them and their group in transitioning from one to the other. This seems like the crucial thing to understand and probably a skill gained more through experience than simply reading about it.