If you’ve been reading the French press recently, you are no doubt aware that this week represents the start of a new adventure… I’m of course referring to the imminent road show for Facebook’s IPO.

Already affecting a billion people on the planet, and probably 100% of RudeBaguette readers, Facebook strikes me as the perfect trigger to kick off a discussion on this blog about IPO’s, specifically their role in European venture-backed technology startups. This post represents the first installment of a multi-part series on the topic.

Today we’ll first discuss a few IPO basics, and in a later post touch on the specific implications for our market here.

This is only the beginning…

One could be forgiven for viewing the IPO event as an end goal. The media encourages this notion by reporting on the ‘home run exits’ for the VC’s, or on the newfound wealth of company founders and early employees, as if now they all hit the jackpot and are taking all their chips off the table. But like the first word in the I.P.O. acronym, the IPO event is really more of a beginning than an end for a company and most of its stakeholders.

An initial public offering is the first sale of stock by a company to the public. A company can raise money by issuing either debt or equity (the joke in France is that there’s a third option: subsidies). Anyway, when raising money via equity, a company can tap accredited investors (e.g. VC funds, high net worth ‘sophisticated’ individual investors, or other institutions and corporations); or additionally, a company can offer shares to the public markets. When restricting its equity issuances to a limited number of accredited investors, the company remains private. In the latter case, the company takes on the new status of public company, begins trading on a public stock exchange, and becomes subject to a new regulatory framework, governed by the SEC in the U.S. (the AMF in France) designed to protect public investors.

Pros and Cons

The Wikipedia entry on IPO’s discusses the fundamentals in more detail, but in summary the rationale for a company to consider going public can encompass the following:

• Strengthening and broadening the equity base
• Starting the process of creating liquidity for the initial shareholders
• Attracting and retaining employees through equity on a liquid market
• Facilitating future access to capital and creating new financing opportunities
• Exposure, prestige and public image
• Facilitating acquisitions

And of course being public can entail any number of drawbacks:

• Significant legal, accounting and marketing costs
• Ongoing requirement to disclose financial and business information
• Meaningful time, effort and attention required of senior management
• Risk that required funding will not be raised
• Public dissemination of information which may be useful to competitors, suppliers and customers
• Increased pressure on short-term financial performance

Process

The process of going public typically involves one or more investment banks which are known as “underwriters”. The company going public enters into a contract with the lead underwriter to sell its shares to the public. In a song-and-dance routine dubbed the “road show,” the underwriter approaches investors with an offer to sell the company’s common shares. Upon selling the shares, the underwriter(s) keep a commission based on a percentage of the value of the shares sold.

In addition to investment banks, and because of the wide array of legal requirements, IPO’s typically involve one or more law firms with a deep practice in securities law.

Public offerings are sold to both institutional investors (such as mutual funds, or in France, SICAV’s and even tax fund management firms) and to retail customers (the general public, e.g. widows and orphans). Because of the tendering of shares to the general public, the process is closely regulated. For example, in France a company going public must obtain two steps of authorization from the AMF, and publish a detailed prospectus (‘document de référence’) while adhering to a variety of deadlines and notice periods.

Following the road show and compliance with all regulatory requirements, the underwriter sets a deadline for the investment commitments from the institutional and retail investor groups. At some point almost in parallel, the company and its advisors will likely choose one of two primary ways of setting the price of the shares being sold: either i) by announcing a fixed price, or ii) by going through a process of ‘book-building’ in which the underwriter attempts to gauge investor demand for the IPO and thus determine the most appropriate price which will ensure the fundraising target amount is met.

If and when the targeted fundraising amount is attained, the IPO operation will generally be deemed a success. The underwriter often is allowed to increase the size of the public offering by up to 15% under certain circumstances (known as the ‘greenshoe’ option).

The investment bank underwriting the IPO will often also initiate research coverage on the company so that their corporate finance department and retail division can attract and market new issues.

Stock Exchanges

Finally, a word on the public markets. The stock exchanges with some minimum degree of pan-European exposure that would be relevant for a French company are:

• Euronext (which in France includes the Alternext and the Marché Libre)
• OMX (headquartered in Stockholm)
• London Stock Exchange and AIM
• Deutsche Börse

Additionally, practically every European country boasts its own stock exchange (Borsa Italiana, Helsinki Stock Exchange, etc.) which generally is more appropriate (and often restricted, even) to listings in the home country.

We’ll elaborate on these points further in the context of European tech companies in a future post.

Fred Wilson ran an excellent series recently on his blog about startup boards of directors. The series began with several posts of Fred’s typically concise and valuable insights, and subsequently featured guest opinions from a number of experienced practitioners in the ecosystem.

I encourage you to read them all (start here) when you have time and come back to this post later if you like.

One of Fred’s pearls of wisdom on board meetings struck me as particularly relevant for startups here in continental Europe:

“Board meetings should not be held for the benefit of the board; they should be for the benefit of the CEO.”

This message resonated with me when I think about board meetings in many venture-backed startups here. VC’s often dominate the boards of European startups, certainly in terms of influence if not in full legal voting majority. Board composition in European companies is closely correlated with the company’s corporate form. In Belgium and the Netherlands, for instance, the common BV corporate entity has a two-tier structure, with a board of supervisory directors separated from the board of managing directors. In France, a startup may have a single tier structure (conseil d’administration) but frequently adapts a two-tier one at it matures (directoire + conseil de surveillance). Because of the absence of management in the supervisory board layer of a two-tier structure, this organ is commonly controlled by the VC’s.

This is certainly not a problem per se. However, a VC-dominated board can create an environment in which the management team comes to regard the board meeting as a reporting obligation to plow through, i.e. a quarterly or bi-monthly chore. A European VC tilt toward under-capitalization — or at least the reluctance to fund outsize financing rounds that give even those companies with a high burn rate an extended cash runway — can keep startups on a tight financing leash and thus also reinforce the headmaster/pupil dynamic.

The consequence is that board sessions turn into operational update exercises as opposed to truly open exchanges on the most important strategic issues facing the company.

So how to avoid this trap ?

Both the VC’s and the entrepreneurs are responsible. As VC’s, we should communicate clear expectations and board meeting rules of engagement to entrepreneurs at the time of the deal. We should also take care to isolate the important but operationally-oriented reporting items to a place outside the boundaries of the board meeting.

Entrepreneurs, and this can be uncomfortable, need to learn how to (politely) say ‘No’ to VC requests to add non-strategic topics to the board agenda. Rather, they should be strict in prioritizing the most important strategic topics for discussion and should view each board meeting as a chance to share (as Fred called it) “the issues that are keeping them awake at night.”

Then we’ll all get a good night sleep.

Pardon the overused cliché, but I figured it was appropriate to pay homage to the 100-year anniversary of the Titanic’s fatal voyage since every media outlet seems to be doing so (my favorite was The Onion’s commemorative tribute in applying its rarely-used 100-point font to the headline).

But the equivalent of rearranging deck chairs on the Titanic is what it feels like we do all too often here in France.

My favorite local neighborhood wise man and actuarial genius, Joseph Leddet, recently described the manifestation of this phenomenon in the Paris metro system. RATP employees in 9 out of 10 metro stations no longer sell tickets; they’ve been re-commissioned as “public information points.” As Leddet points out, this means that the employees in 9 out of 10 metro stations have nothing to do, because regular metro passengers have no need for “public information.” They merely need to buy metro tickets or renew their monthly pass. And now the employees can no longer render such a service; they merely redirect the passenger to the automated ticket kiosk. So, since the employees still maintain their positions in the metro stations, no cost savings are realized. Nor are they re-trained and re-deployed in other innovative areas that could, heaven forbid, actually become new revenue lines for the RATP. And since the automated kiosks are incomprensible to most tourists and incompatible with many foreign bank cards, one could argue that there’s a been a regression in the notion of public service.

Yet this phenomenon also extends to the high-tech startup scene.

I’ve written a lot about the Easy Money period and the distorting effects that tax-incentivized investment vehicles can have on France’s venture capital industry. The rearranging deck chairs metaphor comes into play when we think about the perverse impact on the efficient allocation of capital. As I’ve suggested before, tax-incentivized funds prioritize capital preservation over high risk/high reward pursuits.

High risk-taking inevitably means some bankruptcies. Bankruptcies can endanger the gravy train of intermediaries that push these investment vehicles on French taxpayers looking for a fiscal break. So rather than allocate capital to high-risk endeavours that have the chance to become the next Twitter, it is much more prudent to invest in relatively safer technology or service businesses that sacrifice growth in favor of short-term profitability. Or worse, to drip feed companies that once had a technology edge but never quite scaled when now their market opportunity has long since morphed into something else.

Happy anniversary.

In France we’re now entering what I think of as the “easy money period” for startups. The easy money period begins roughly around April 15 (purely coincidentally, the U.S. tax filing deadline) and runs until June 15 (the French wealth tax filing deadline, and that’s no coincidence).

To be fair, fundraising in a startup is never easy. The fundraising process represents a substantial effort in time and distraction for the entrepreneur, even during the frothiest of times.

But stimulated by fiscal measures in France, the two-month stretch between April 15 and June 15 has become a period in which a wave of investment vehicles come out of the woodwork in a rush to invest in French startups.

The genesis of this wave began in August 2007 in the form of a French law enacted to stimulate work (travail), employment (emploi), and purchasing power (pouvoir d’achat), abbreviated as the “Loi TEPA”. While this law encompasses a basket of tax incentives, the most impactful for the venture capital industry has in my opinion been the component that treats the French wealth tax.

The French wealth tax (ISF) represents a progressive tax on households possessing net assets exceeding a certain threshhold, formerly at 800k€ and now at 1.3m€. The annual filing deadline for the ISF tax return is June 15.

Specifically, under the Loi TEPA, French taxpayers liable to the ISF can receive an immediate tax deduction on investments they make in French SME’s that are not publicly-quoted. This tax deduction reached as high as 75% in 2010, though now has been trimmed back to 50%. In other words, a taxpayer that invests 90k€ in a French startup before June 15 will receive an immediate deduction of 45k€ on his ISF tax. Of course, certain boundaries apply, for example, the total deductible amount is capped at 45k€, and the SME must meet certain criteria, notably a number of employees below 2,000 and a business activity that is considered “innovative.” While SMEs in other EU countries and even non-tech industries may qualify in theory, the upshot is that this ISF tax deduction is easiest to justify for investments in French high-tech startups.

The French seem to be even more passionate about tax deductions than about foie gras or fine wine. And the amount of ISF tax receipts in France is significant (3.8m€ in 2008). So, investment vehicles which offer ISF tax deductions are popular among the French upper middle-class. Moreover, private bankers love these ISF Funds; they represent another investment product they can push out to their wealthy clients which is an easy sell and hence a fast fee generator.

As a result, ISF Funds are numerous. And they target investments in the very same companies that traditional VC funds would target.

However, the nature of these ISF Funds leads to one key distinction: since the investors in these vehicles have already received a significant tax deduction, their ROI requirements on the performance of the funds’ underlying investments is less important. In fact, a general perception among ISF Fund investors, rightly or wrongly, is to be satisfied with a money-back situation. If the ISF Fund returns exactly the original investment, say 5 years later, one could argue that the performance of the Fund is unacceptable. Yet the individual investor will be delighted with his tax-adjusted return, thanks to the significant fiscal deduction at entry.

This key distinction creates a mismatch in the market relative to traditional VC funds. On the one hand, an ISF Fund does not require the same rigor and high-calibre team necessary in a traditional VC fund. Traditional VC’s must keep their institutional investors happy; and it is largely on the basis of their track record that they succeed or fail in raising future funds. Raising an ISF Fund does not require a road show, merely the right distribution network to reach the individual taxpayers with a no-brainer product.

Additionally, thanks to the existence of the “tax shield,” an ISF Fund can thus afford to invest at higher valuations than a traditional VC whose investors’ IRR will be based solely on the capital gains.

So the existence of these vehicles is a double-edged sword. For entrepreneurs seeking to raise money at higher-than-market valuations, the ISF Funds can be a relative easier source of funding. Decision cycles with these vehicles tend to be fast too, as they must invest before June 15 to qualify for the tax deduction.

On the flip side, the entrepreneur may in return forfeit the longer-term benefits of partnering with a VC firm who will be laser-focused in adding value in whatever way they can (network, recruiting, m&a, international expansion, etc.) with the sole objective of maximizing capital appreciation of the company.

As style entrepreneur and design authority Tyler Brûlé once astutely observed, it’s always a good time to visit Tokyo.

I had the honor of spending the past week there on a business trip, which by stroke of good fortune, coincided with a week of cherry blossoms (sakura) in full bloom.

Appreciation of the fleeting moment of flowering cherry blossoms and the corresponding hanami celebrations are typically Japanese traits.  The blooming of the sakura marks the arrival of spring, representing not only a renewal of the seasons but also a rebirth of many facets of life: the start of a new school year, a recalibration of personal goals, and a reassessment of business objectives.

One industry undergoing dramatic rejuvenation which interests me professionally is the gaming sector.  Historically. Japan has produced worldwide leaders in this area: card games like Hanafuda which my Japanese aunt’s grandparents played as kids, arcade games from companies like Konami and Namco (remember Pac-Man ?), later giving way to console games from goliaths like Sega and Sony, only to be subsequently out-innovated by Nintendo’s Wii.

Today, the gaming sector faces a new kind of disruption in the form of social games.  In the West, we cannot escape almost daily coverage in the tech press of social game darling Zynga.  However, the true leaders of this sector are in Japan:  notably DeNA and Gree – two incredible success stories with market caps comparable to Zynga yet with operating margins exceeding a whopping 40% – and to a lesser extent Nexon, a Korean company recently succeeding its IPO on the Tokyo Stock Exchange as well.

Oh and by the way, unlike Zynga, these two Japanese leaders operate their gaming activities almost exclusively on mobile.

I submit that the nascent market of Europe, particularly France with its deep bench of game development talent, can learn a lot from these giants.  For example, a relentless focus on market iteration helps these firms develop advanced insights into customer experience.  These insights translate into savoir-faire in monetization, resulting in ARPUs surpassing the already impressive figures of Zynga by 3~5x.  Applying just a fraction of those metrics to the European market produces some insanely audacious projections.

But like the short-lived blossoming of the sakura, the current gaming model will not last indefinitely.  Already rumors swirl about the prospect of increased government oversight and potential regulation of the highly profitable free-to-play/upsell model.

Combine this risk with a saturated domestic market, a strong yen, and a new generation of internationally-minded Japanese entrepreneurs, and we have a perfect storm of convergence for adventures abroad, such as DeNA’s acquisition of Ngmoco and Gree’s acquisition of OpenFeint in the past 18 months.

On my last night in Tokyo, my dinner companions spoke about the general macroeconomic situation facing Japan, and one person even posited that Japan should look to France as a model for how to gracefully manage a once-leading economic superpower in its gradual decline.

The suggestion that Japan could actually learn something about economics from France definitely caught me off-guard.  But it was a typically Japanese thing to say, a phrase filled with humility and perspective.

My gut feeling, however, is that Japan will continue to reinvent itself.  After all, the creator of the original hanafuda paper card game fell from grace only to later rise again with a blockbuster success: Nintendo.  Wii shall overcome.

I don’t think a week goes by in our office without at least one fundraising pitch employing some variation of the phrase, “These financial projections are conservative.”

I understand the well-meaning intent. The entrepreneur’s objectives are often twofold: i) convey us that the market potential for the given startup is enormous; and ii) convince us that the entrepreneur will be a prudent steward of the investor’s capital.

The first objective reminds me a bit of the Chinese market analogy, i.e. if we sell this to only 0.1% of the Chinese market, look how many millions we’ll make! This is problematic for me because it underscores a top-down approach to market research. Top-down analysis is a useful sanity check to test assumptions — most investors will do this anyway — but it is anathema to the fundamentals of building a successful product in a startup, i.e. determine a pain point in the market, develop a prototype or alpha version to test your thesis, iterate based on customer feedback, then scale. It is far easier to extrapolate projections into large numbers once these preliminary proof points are in place.

The second objective is more complex. On the one hand, I can certainly appreciate the entrepreneur’s desire to reassure us of their frugality. Resourcefulness is a key character trait of a good entrepreneur, and I want every entrepreneur we support to be efficient with our capital.

However, to creators of high-tech startups with conservative aspirations, I say, you’re in the wrong place. Either you’re not ambitious enough to launch a company that can attain the growth on which venture capitalists rely, or you’re telling me what you think I want to hear. Don’t get me wrong, not all business ventures should target explosive triple-digit growth in their early years. Lifestyle businesses are perfectly laudable, and I commend the entrepreneurs that create them. But the VC model is predicated upon outsize returns. If the growth that can generate outsize returns is not relevant for your business, then venture capital is not the relevant source of financing.

I can also understand why you might downplay your projections, even if you’re concealing your genuinely lofty ambitions. The French educational system, such as the noteworthy Ecole Polytechnique, prides itself on training future business leaders to perform exhaustive what-if analyses and risk-avoidance simulations before finalizing any decision that contains a tad of uncertainty. Moreover, as VCs in Europe, we’re collectively guilty of reinforcing such behavior by chronically under-capitalizing startups and typically favoring profitability over revenue growth. There’s also the cultural element, which I find both unusual and admirable as an American, of the European values of modesty and not over-promising.

Think BHAGs

Jim Collins in Built to Last famously cited the BHAG acronym — big hairy audacious goal — as a consistent characteristic of visionary companies. I submit that BHAG thinking is also a fundamental tenet of successful entrepreneurs. It is only by setting the bar high, by being audacious in your plans, by being overly-ambitious in your efforts, that heroic results occur. I expect you to fall short in your forecasts; a business plan never shakes out as projected. But you need to aim for Mars if you merely want to reach the moon. Perhaps the golfing metaphor would be, “A short putt never drops in the hole.”

Oh, and please don’t generously propose to be a diversified lower risk asset for our portfolio. VC’s will perform their own risk mitigation exercises. This forms the basis of professional portfolio management, and heck, half of the VC’s in Europe are former bankers. Furthermore, risk mitigation is built into the very architecture of the venture capital model in that LP’s allocate only a fraction (<1% in Europe) of their total funds under management to the VC asset class.

So if I were asked to articulate what I would ideally like to hear in an entrepreneur’s pitch to ensure they capture my attention, it would probably include something like this:

Imagine this scenario: You just completed a full day of second-round interviews at the Company’s premises following your successfully making the first cut at their on-campus recruiting session. It was a long, grueling day, but you feel good about the positive impression you made on everyone. Your well-prepared questions clearly hit the mark, and you even aced the unconventional case interview thrown at you by some over-zealous middle manager that thinks his Fortune 500 firm should emulate McKinsey-style recruiting methods. The informal dinner at the end provided you with a chance to meet other employees with whom you didn’t interview, and you found them witty, collegial, and overall representative of a company culture that feels like a good fit. All that remains in your mind is to await the call from HR next week to hear the collective feedback on your candidacy and hopefully review the details of a job offer. You acknowledge that there’s still some uncertainty, but you’re optimistic.

The call from HR the following week came as expected, but their request was one you did not expect. The HR manager conveyed the positive feedback on your candidacy, but then informed you that in order to continue the process, they require the keys to your apartment for a few days.

The Company intends to examine your personal affairs before making a final hiring decision. They will have an opportunity to examine the cleanliness of your living quarters, check the expiration dates of the perishables in your fridge, sniff the mildew on your dirty laundry, and perhaps find that 1980′s copy of Playboy with the Farrah Fawcet centerfold stashed under your mattress (yes I’m thinking of you, Brian Miller from the 8th grade). The Company may riffle through the papers in your filing cabinet, thumb through your photo albums, jam to your Bob Marley cd collection, and watch the latest recordings on your DVR.

But don’t worry, they won’t take anything, and they’ll be careful not to break anything. This exercise is merely standard procedure to ensure that you’re a good fit before their final hiring decision. They won’t even make copies of anything they discover; after all, the Company respects your privacy.

{Note: My portfolio companies’ recruiting methods are limited to obsolete techniques like merely asking candidates for references.}