500 Startups and Conglomerate Theory

In early October, I had the good fortune of seeing Dave McClure, founding partner of 500 Startups, at the Geekwire Summit in Seattle, WA. McClure, with his humor and charisma, had the crowd roaring with laughter as he opined on the venture capital industry. 

McClure's philosophy of venture capital is unique: he wants to be big, but not just for the sake of being big, but also for the sake of diversification. He hates the idea of having a few portfolio companies, knowing that only about 10% will be wildly successful. If the rate of success is so low, why not just have more portfolio companies? "I would say spray not pray" says McClure of his investment thesis. The diversification in his portfolio mimics asset allocation techniques of typical Wall Street managers.  

Fund of funds, however, are circumspect about investing in 500 Startups for various reasons. Michael Kim of Cendana Capital likes investing in VCs that take big bets because the chance of big returns is higher. 

Jason Lemkin of SaaStr notes that while IRRs have been higher than most VCs at 500, given its early stage of investing, cash-on-cash returns may take longer to transpire at 500 than at other VCs. 

When I heard McClure talk about valuing diversification so highly, I instantly thought of conglomerate theory in corporate finance. Although there are a lot of differences between a traditional conglomerate and a large VC, there are certainly some similarities. Early stage VCs such as 500 do have operational roles in their portfolio companies, the way a Berkshire Hatahway or GE do. VCs are heavily invested in their portfolio companies, and, especially in the case of 500, the synergies are more financial than operational. 

What are some of the reasons investors eschew conglomerates? For one, there is an inherent bias against growing for the sake of growth, and it is believed that conglomerates are in a precarious position for doing just that. "Many conglomerates remain obsessed with empire building, sacrifice value for growth, overpay for acquisitions, hang on to businesses that will never prosper (or would perform better in other hands) and fail to develop structures, impose disciplines and create cultures that sustain value growth." according to Kaye and Yuwono of Marakon Associates. So the question related to 500 Startups would be: Do we think McClure is growing the VC just for the sake of being big? At some point, does adding lots of startups mean that investment criterion have become less stringent? 

Another reason money managers prefer non-conglomerates or core businesses is because they view diversification as a job better done by portfolio managers, not management teams. An investor may want to invest in the healthcare sector of GE but not the oil and gas sector. So if she does buy GE stock, she'd to pay a discount for having to invest in an industry that does not interest her. In terms of 500 Startups, do the fund of funds believe that they can do a better job than McClure of diversifying the venture portfolio? What if investors want to support startups in Asia but not Europe and would rather choose geographically focused VC? 

To be fair, there is a conglomerate premium for conglomerates outside of the US, as noted in this HBR study, for reasons that may also apply to 500 Startups. For example, a conglomerate in an emerging market may be able to operate each segment of the business better together because it may be able to navigate the regulatory and political environment better than anyone else. 

McClure argues that the reason for diversification of 500 Startups is so that the companies can access a wider network of experts, thus providing an operational edge to each of those companies. He says that VCs would like to believe that they are brilliant, but investing in 30 companies is no guarantee that one will hit the $1bil mark. But doesn't buying up a myriad of companies in all different sectors and geographies smell like an index strategy? 

Axiomatically, I don't like the idea of playing the numbers game in VC. To me, it sounds like accumulating the most start-ups is akin to investing in the market or chasing beta. By saying VCs aren't "brilliant", he's implying that there's no alpha, so he's employing a benchmark strategy.

But there IS alpha in venture capital! There has to be, right? VC is one of the least efficient markets out there: transaction costs are high, information is asymmetrical, access to investments is limited in many cases, VCs are not rational, and pricing is turbid. All of these inefficiencies, at least theoretically, allow for opportunities to outperform (or underperform) the market consistently (not based on luck, as efficient market hypothesis would suggest). Isn't this why Sequoia and Benchmark outperform, because they are able to generate alpha? 

If 500 Startups is outperforming, I think it's because McClure is more "brilliant" at picking and operating good companies than he is giving himself credit for, and not just because of having lots of companies in his portfolio. 

For more on pluses and minuses of conglomerates, go here. 

Food Delivery Services: Lessons From Struggling Grocery Stores

This post was originally published on Distressed and Turnaround Blog in July 2015. 

With increased competition, sky high operating expenses, and little room to pass on any increased food costs, American grocery stores have long faced a tumultuous battle to survive. And yet, online food and delivery services are winning VC capital with no end in sight. It's difficult to imagine that online comestibles shopping will stultify grocery stores the way Amazon has for brick and mortar retailers. It is however, prudent for each food-related sector to learn survival tricks from the other. 

In regards to grocery stores, barring the recent Albertsons' IPO (which has its own turnaround story from the SuperValu days), news has been pretty dismal. There are reports that A&P is close to filing for bankruptcy protection for the second time in five years due to high debt payments, competition from Whole Foods & Trader Joe's, and high pension costs. Haggen, which bought some Safeway and Albertsons stores recently, announced  that it will be cutting some labor expenses. 

And last November, Dahl's Foods, an 83-year old Iowa based filed for Chapter 11 and agreed to be acquired by Associated Wholesale Grocers. The company claimed that it was "slow to recognize the competitive threat and to make the operational changes necessary to remain viable. During this period, the debtors over-leveraged their assets as their revenues declined and became under-capitalized."

In contrast, web-based food and grocery delivery services has been one of the hottest VC sectors, with more than $1 billion invested since 2014, almost a four-fold increase year-on-year, according to TechCrunch. 

Actually, TechCrunch's piece on Food Delivery Wars is a good primer on various offerings backed by Silicon valley today.

So what lessons can these hot delivery services learn from supermarkets and their struggles? Some of the obstacles that led to the demise of grocery stores won't apply to online services, such  as high pension or rent expenses. Other challenges, however, may appear to delivery services in disguise. Here are a few tips: 

Customers are fickle and it's best to have the option to adapt. Consumers crave variety over time, and you want to avoid A&P's fate of not being able to make operational changes to remain viable. For example, Sprouts Farmers Market increased its productivity by 15% by shifting its focus from being a specialty store to an everyday healthy grocery store, according to SuperMarket news. If a delivery system isn't able to get adequate revenue or customer growth, it might be time to think of adjacent products to offer, both to retain existing customers and entice new ones. This sounds intuitive, but it's surprising how many delivery services have a limited scope, whether it's a small number of restaurants contracted or services that only deliver cold pressed juices. And it that vein... 

Data are your friend. Since consumers are fickle, the only way to stay abreast of trends is by collecting and analyzing data. Albertsons', for example, uses extensive data to systematically monitor emerging trends in food and source new and innovative products, according to its S-1.  

Munchery is a good case study of an online service using data to optimize its sales. The food delivery system couldn't figure out why some of its chef-prepared gourmet meals weren't selling. Contrad Chu, the entrepreneur behind the concept, used Desk.com from Salesforce to track customers’ order histories and food preferences, as well as company mentions on Twitter and other social media feeds. This helped Munchery spot and react to macro taste trends such as kale mania, the Paleo diet or ethnic foods. 

Data are especially important for delivery services that touch products, like Munchery, Plated or Blue Apron. If you're putting in the effort to obtain ingredients, prepare (or pre-prepare) the meals, and package them, you want to make sure that they'll be a hit. Social media is a great tool to glean these trends. Fast food restaurants such as Taco Bell use data from social media to get an early indication of which products are working and why. For earlier stage startups trying to understand their addressable market, there are a number of analytics firms that excel at collecting and interpreting these data, which could be helpful before product launches.

Keep expenses tight. Unlike traditional grocery stores, delivery systems don't have the problems of yesteryear such as pensions. Having lean operations from the get-go, however, will help online companies weather difficult times. And while many services, such as Fresh Direct, have an excellent supply chain that affords it to minimize shrink and waste, start-ups without that kind of scale may have not have that negotiating power. 

Instacart, for example, has a powerful software that that keeps a tally of how fast orders can move through the system at any given time. “We have an algorithm that runs every minute of the day that evaluates what orders we have, what supply we have, and whether or not we can take a one-hour order and place it on time. Before you’ve even placed an order, we’ve done all the math," said Instacart co-founder Max Mullen.  What that means is Instacart doesn't need to have an extra worker, driver or even packaging material with its ability to forecast demand. With the information collected from its app, Instacart is able to predict when customer orders will come in and for what items, so that it is able to manage its supply chain and operations efficiently. 

Obviously, operating expenses are less important for SaaS companies that don't actually touch the products, such as GrubHub. In such cases, something in addition to the software may help sell the product, such as a network effect, also offered by GrubHub. 

Expect a lot of competition. Everyone eats, so the total addressable market for food should grow more or less with population. Sure, maybe there's some room to expand the pie, but for the most part, when one company gains market share, another loses. Grocery stores have learned that the hard way, with increased competition from superstores such as Walmart and Target, discount retailers such as Aldi or even the dollar stores, and lastly, the advent of online food delivery services. And many grocery stores aren't taking it lying down; they've realized they need to get into the home delivery and online shopping on their own. 

Although the Internet is rife with advice for entrepreneurs about gaining a competitive advantage, one way to gain scale is to collaborate with providers for adjacent products, because that is essentially what the big box retailers do. A group of best-of-breed online food services can gain scale quickly and control costs by having increased negotiating power with suppliers or vendors. They'll have more data to assess consumer behavior and sell what works. Sure, it requires some creativity and innovation, but there's no shortage of that in the food start-up land. 

Fashion Risk

This post was originally published in Distressed and Turnaround Blog in July, 2014. 

Fashion is risky business. Who knows what works? In the investment circles, buying stocks or bonds of a company that sells modish products is referred to as taking on "fashion risk". Rightfully so, because many of them fail, with the most recent example being Coldwater Creek. In this post, I will use Coldwater Creek as a case study for some of the possible pitfalls for an apparel retailer and discuss strategies for convalescence.

Coldwater Creek, a specialty clothing retailer, filed for bankruptcy on April 11. According to the recent liquidation plan, all term loan, priority and secured claims will be paid in full. Unsecured claims would recover an estimated 4.43%. TheDeal.com

The retailer was once beloved by middle-class, professional women for its effortlessly chic styles. It started as a catalog company back in the 80s and soon began opening retail stores in the 90's.

"The shopping centers, located in upper-middle-class neighborhoods, cater to the company's core audience: women who earn an average of $70,000 a year and who are drawn to such Coldwater Creek staples as $79 burnished silk jackets and $65 reversible suede belts... 

(Dennis) Pence is rushing to capitalize on an emerging demographic group that retail experts have dubbed the zoomers. They are baby boomers with a zest for living" Bloomberg BusinessWeek

Fast forward to April 2014 and the Company filed for bankruptcy after attempts by the debtors to refinance the debt, recapitalize the balance sheet and even sell the enterprise outright failed. What happened?

       

2007 happened, and everything went downhill from there. Net sales declined approximately 32% from its peak in 2006 to $742 million in 2013. The Company has cited everything from a slow-down in traffic to merchandising issues for the steep decline in same store sales. Following the reduced revenues, the buildup in inventory and its subsequent markdowns resulted in a deterioration of margins.

James A. Bell, EVP, COO and CFO of Coldwater, stated in the Declaration in Support of First Day Motion:

"From 2011 to 2013, the Debtors attempted a targeted turnaround process, which focused on the following:  a) incorporating cross-channel discipline into product and creative functions b) establishing the foundation of product assortment architecture c) acquiring retail-centric talent d) developing and implementing a real-estate optimization program e) positioning the brand strategy to ensure focus on target customer and f) re-engineering design and product development functions." Pacer

In order to gauge what the problems could have been, I did a little digging online for reviews from customers and employees. Here are some quotes that sum up many of the issues.

"Coldwater Creek USED to be a place women could go to find elegant, classic fashions. This year (2013) in particular, they have seemed to slide down that same slippery road as JC Penneys and KMart, which has resulted in imported, tacky, frumpy-looking clothing." Customer, May 2013

"I hear CWC is trying to grow back its customer base, but I just took a look at their website. Styles are dowdy and colors are drab. With my past experience with CWC poor quality and fit, there is nothing that tempts me to try again." Customer, October 2013

"Return policy is too liberal. End the 'anything, anytime, for any reason' deal." Employee, November 2011

"People bring stuff back from 5 years ago and get money or a gift card." Employee, December 2011

"While the employee discounts are good, the quality of the products have dramatically declined over the past 3-5 years." Employee, August 2012

"They are trying to change their entire customer base and it makes it difficult for the store emplyees to help the customers that made the company so popular to begin with. Not every customer wants short sleeve tops, slim leg jeans, and shapeless tees. Bring petites back to the stores we are losing customers everyday because we are only carrying pants in the store. Same with 3X sizes for customers." Employee, August 2012

A few observations:

1.  Returns Policy- I wouldn't recommend any turnaround strategies without a through quantitative analysis of costs and benefits. That said, anecdotal information could point to where corrective actions may be necessary. Depending on the negative contribution margin due to returns, the policy may be significantly hurting profitability OR it may just be a perk that doesn't make a significant difference in the bottom line. It would be helpful to do a margin impact (since nonperforming inventory is liquidated to offset some of the cost) curve based on the difference between time of sale and time of return to see if the returns are a significant hit to profitability. 

2.  Fast Fashion- In the mid 2000's with increased globalization and textile outsourcing, the fashion game changed. Zara is often noted as the pioneer of "fast fashion", an idea that fashion should be as responsive as it is innovative. Unlike traditional fashion labels that produced two main collections a year, fast fashion concepts such as Zara, H&M and Topshop design, manufacture and deliver many collections over the year to drive traffic. The two main determinants of fast fashion are short production and lead times and highly fashionable product design. Here's more from a Wharton paper:

"Short lead times are enabled through a combination of localized production, sophisticated information systems that facilitate frequent inventory monitoring and replenishment and expedited distribution methods. 

The second component (trendy product design, Enhanced Design) is made possible by carefully monitoring consumer and industry tastes for unexpected fads and reducing design leadtimes. Benetton, for example, employs a network of "trend spotters" and designers throughout Europe and Asia, and also pays close attention to seasonal fashion shows in Europe." Cachon and Swinney, "The Value of Fast Fashion".

The benefits of quick response strategies influence consumer behavior by reducing the frequency and severity of season-ending clearances. Enhanced design capabilities result in products that are of greater value to the customer in the present time and exploit this greater willingness-to-pay by charging higher prices on trendier pieces than on basics.

In contrast to the fast fashion front-runners, Coldwater Creek explains its merchandising process in the 'Risks' section of its 10-K:

"On average, we begin the design process for apparel nine to ten months before merchandise is available to consumers, and we typically begin to make purchase commitments four to eight months in advance. These lead times make it difficult for us to respond quickly to changes in demand for our products...

Our inventory levels and merchandise assortments fluctuate seasonally, and at certain times of the year, such as during the holiday season, we maintain higher inventory levels and are particularly susceptible to risks related to demand for our merchandise. If the demand for our merchandise were to be lower than expected, causing us to hold excess inventory, we could be forced to further discount merchandise, which reduces our gross margins and negatively impacts results of operations and operating cash flows." 

Coldwater Creek 10-K. 

Essentially, the Company is making bets about what will work in fashion 4-8 months in advance. For equity holders, that is like investing in a company that buys forward contracts based on fashion trends!

I am not suggesting that an apparel designer and retailer aimed at women in their 30's to 50's ought to carry pieces trendy enough for teenagers, but it does help to be more nimble when it comes to responding to consumer demand. And in order to be more reactive to consumer demand, faster lead-times are essential.

Of course, there is a trade-off: faster lead-times and enhanced design require giving up a lot of design control and following trends in an efficient way. For example, Zara's designers work to imitate fashion, rather than innovate fashion. Only the fabrics are ordered before the season starts due to long lead times, but even those are ordered uncolored so there is flexibility on changing them right before the order. Suppliers have more autonomy in design, so they become more of strategic partners rather than just an operational necessity. Zhelyazkov, "Agile Supply Chain". 

3. Technology- As a retail grows into servicing customers through multiple channels, it's IT system becomes incredibly important. Macy's merchandising initiatives called My Macy's and Omni-Channel were initiated in 2009 as a way to delight customers at a local level and provide a a seamless shopping experience regardless of the channel. Of course, this required significant IT capacity. 

"A single platform or visual merchandising software enables retailers to also extend the reach and relationship with their product suppliers, giving them insight into the merchandising process and ensuring they are able to act more quickly and sharpen their merchandising execution."  Retail Customer Experience

"Most retailers cannot match Macy's spectrum of Omni-Channel initiatives because they have not created the multi-year master plan needed to achieve it. Many retailers have not allotted the investment required to create accurate, real-time views of inventory, order management, supply chain." Seeking Alpha

Migrating everything over to a single ERP platform from various databases can be very costly and operationally awful; just ask Levi Strauss about its SAP disaster! In addition to an ROI analysis, it would be useful to examine scenarios where such a migration could go wrong and assess the possible impact of the worst case scenario before deciding on a solution. 

Lastly, an important public service announcement: Many firms lose touch with employees on the field and their customers as they grow. It should go without saying that employees in the front lines should be empowered to voice their concerns, those opinions should be an important part decision making process, and the reasoning behind those decisions should be freely shared with the employees. "Store employees can in turn provide faster feedback when a campaign has been executed so corporate has a clear understanding of compliance, the impact an accurately executed campaign has on sales and the customer feedback from that geographic market," Retail Customer Experience. Open communication within a company goes a long way and could make the difference between success and failure.