Monetary Policy As a Cause of Global Food Inflation

An idea I presented at the 2013 “Non-Obvious Dinner” April 2nd in Wilmington, DE

The history of the next 5 years will be told in prices of corn and onions

–World will see major food inflation with significant political and economic consequences

–Government policy in the developed world is focused on asset price stability

–Official “core” inflation numbers exclude food and energy

–Policy does not address food prices which

–represent 50% or more of the income of citizens in the developing world

–and which are rising at 3-5% more per year than official inflation numbers

–In 2007 and 1H 2008, we saw a preview of this when record wheat and other food prices caused riots in 22 countries.

–This event was driven mostly by extreme weather events.

It was the first chapter where we saw food prices contributing to political unrest

–wage increases needed in China, which has seen a 10x hourly increase in last 15 yrs

–Note that the US worker is 5x as productive as the Chinese counterpart (due to high US automation).  When the average hourly wage in China crosses $4, as it has due to the demand by workers, it approaches parity with the US worker.

–Food inflation also contributed in part to the Arab Spring.

–More recently, the demand for higher wages in response to food price increases led to shooting deaths of 34 miners in S Africa.


–Going forward we have the confluence of extreme weather

–record drought in US in 2012, record flooding in Japan and India (where there are food riots over price of onions)

–Plus depreciating dollar

–US policy makers have strong incentives to inflate their way out of our current debt problems

–This raises price of food stuffs in local currencies globally as many food commodities are priced in USD

–We have already seen record prices for wheat and maize in 2012

–Policy makers are targeting a “core” inflation number for price stability without recognizing the global consequences of their policies.

–Ethanol is a large contributor to rise in food prices.

In addition to predicting the political instability caused by rising food prices over the next 5 years, I foresee two additional changes:  1) strong pressure from the UN and World Bank for the US to limit corn based ethanol production.  2) A move to price global food commodities using gold as the “numenaire” for quoting prices (but not using gold as payment.)

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Why Democracy Itself Will Come Into Question

Idea**:  In the next five years in the US, democracy itself will come into question.
Argument:  Democracy requires four things to support the central concept that every vote be treated equally.  Each of these four premises has individually been questioned, but circumstances will arise to coalesce those discrete criticisms into a unified argument against democracy.

The four requirements for democracy to be possible or viable are:

1) rational informed citizenry, who use free and fair elections, for the

3) delegation of power (in a representative democracy)

4) where the representatives serve the large middle class who are the majority of the citizenry

When these four conditions obtain, it’s possible to believe that all votes should be treated equally.

But each of these four supporting premises has been questioned and weakened.

We know from cognitive psychology and public choice theory that voters do not act rationally even when making decisions in their own self-interest.  We don’t need evidence that they’re uninformed.

2) Elections are widely seen as uncompetitive where the power of incumbency leads to re-election rates reminiscent of the Politburo.  In addition, there’s a long term trend towards non-participation in local and national elections.  On the fairness issue, we still have the legacy of the Bush v. Gore case, as well as lots of noise on the topic of voter fraud, voter ID laws, and the like.

In a representative democracy, delegation of power is logically required, but for it to be effective, the delegate, must be representative of the people who select him or her.  But in our political system, elected office creates a different status, different economics, which serve both 1) to separate the representative from the people electing him, and 2) to lead the representative to exercise power in a self-promoting way, opposed to the long-term needs of the constituents.

4) The Pew Center and others have now shown that the “middle class” is rapidly in decline and is no longer descriptive of a majority of citizens.  Pew’s numbers are that 62% of Americans in 1970 fit the description of “middle class” while only 46% did in 2010.  For the first time in our history, the middle class is not a numerical plurality of the citizenry.  Add to this another historical first:  that for the first time a majority of Americans does not think the next five years will be better than the present.

So with these four logical supports weakened, how can one sustain the argument that all votes must be considered equal when very little equality of any kind exists elsewhere in the country?

In 1835, deTocqueville published Democracy in America, in which he argued, among other things, that Americans craved equality, that equality was the inexorable force in American life.  It led the poor to work harder and provided a union of sorts among Americans from all walks of life and regions of the country.

In 2012, we have never had less equality, or more dispersion of outcomes, in our history.  The gap between the top and the bottom has never been greater with respect to income and wealth, education, and influence.

But democracy requires a narrow dispersion here, and fluidity and mobility among those on the distribution curve.  We now have, and celebrate having, various tribes of the elite: athletes, film stars, politicians, and journalists all now inhabit an elite circle of wealth and influence comparable to the landed gentry in a monarchy.

As the society breaks into smaller groups with increasingly less in common, the country becomes more susceptible to any crisis which challenges the ability of government to respond.  That crisis may be one with respect to the federal budget, the soundness of the dollar, the financial markets, or the geo-political realm.  But whatever crisis arises, if Congress should show itself paralyzed in the face of the need for decisive action, this will be an accelerant for the argument questioning democracy itself.

As for the political poles, it’s easy to locate them in this crisis, whatever shape it takes.  The left will contend that democracy is too cumbersome and requires too much compromise to respond appropriately (we already see this in presidential executive orders).  The right will state that the power granted our leaders by the existing political institutions has irredeemably corrupted our political leaders, who cannot therefore be trusted even to describe the crisis accurately, let alone to face it.

Note that I am not arguing that American democracy will fail in the next five years.  Rather, I am saying that it will be openly questioned.  What was once a minority view of a small fringe element will become widely debated by our elite thought leaders.

**Note:  The above remarks are my contribution to the most recent “Non-Obvious Dinner”.  The Non-Obvious Dinner is a non-commercial event hosted periodically by Henry Mellon, Jeff Rollins, Ben duPont, and Mike Kane.  Each guest is asked to identify a trend not obvious now but which will become known in the next five years.

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Why Successful Entrepreneurs Are So Rare

Success as an entrepreneur requires an extremely rare blend of enormous self-confidence and an abiding willingness to be shown wrong and to self-correct.

The of success as an entrepreneur occur at the intersection of objective real world challenges and the subjective traits of the entrepreneur and CEO.
The objective risks relate to the business case of the company and include such things as technology risk, market risk, and competition. These are all subject to discovery in a thorough diligence process.  Both these systemic and idiosyncratic risks of a start up are typically well identified –though perhaps poorly navigated –by early stage investors.  Less discussed however, and what I want to concentrate on here, are the subjective risks, those peculiar to the entrepreneur himself.

Most experienced venture investors will agree it is a far, far better thing to invest in a second rate company with a first string CEO than to fund an A rated company with a B player CEO.  This statement, which is practically a truism in the venture world, radically contradicts the idea that sufficient diligence of a company’s various objective risks suffices in early stage investing.   There must additionally be an understanding of the strengths and weaknesses of the CEO and these have nothing to do with resume items.

The question clarifies as:  What makes for a successful entrepreneur ?  In my view, for what it’s worth, the answer lies in the mindset of the leader.  The successful entrepreneur has a number of characteristics rare in and of themselves and extra-ordinarily uncommon in conjunction.   These traits include i) vision, ii) confidence, iii) work ethic, iv) self-reflection, and v) a willingness to change course.

The entrepreneur sees opportunities not seen by others.  So by definition, that makes the entrepreneur rare.

:  The entrepreneur next needs the self-confidence to believe both that he or she can develop a solution to the opportunity they uniquely recognize, and to bring this solution to market when often even the customer does not yet acknowledge the need for this.   Steve Jobs made us dependent on things that did not exist until he invented them.
Work Ethic:  Lots of people work very hard, yours truly excepted.  But what distinguishes the entrepreneur’s work ethic is the willingness to work extremely hard now for rewards which are years away, with very low visibility into the shorter term milestones which will make for success.

:  The nature of innovation requires an obsessive focus on the problem to be solved, and the development of the solution.  That is outward looking.  But a great entrepreneur is also deeply reflective, looking inward to understand his or her drive, values, strengths and weaknesses.  Self- reflection is very rare in our age, and extremely rare in combination with these other traits.
Willingness to Change Course:  It is well-known that very successful start-ups have to “pivot” in response to market conditions.  What this requires from the entrepreneur is a willingness to be wrong, to self-correct in order to change course.  And that willingness itself requires an immunity to “confirmation bias”.
Confirmation bias is a behavioral tendency to filter information based on what’s favorable to our existing beliefs.  With all the information that bombards us, the mind uses filters to determine which data are relevant and to assign relative weights to these data.  One of the biggest screens excludes data that contradicts our deeply held convictions.  But deeply held convictions are a basic requirement of the entrepreneur, supporting the confidence and sustaining the work ethic mentioned above.  That willingness to change a core conviction while retaining high self-confidence and avoiding dejection or a desire to give up is an extra- ordinarily rare trait and explains why very successful entrepreneurs are so few.

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American Individualism Will Not Survive a Generation Raised on Social Media

Notes from the 5th Annual “Non-Obvious Dinner”**

The ideal of American individualism will not survive a generation raised on social media.

For nearly 300 years, a paradigm has prevailed of the self-made person, the “rugged” individualist (to use Herbert Hoover’s term), which elevates the person who transcends his circumstances to make his way in the world.  It has been common to celebrate the lives of people like this, such as Ben Franklin, Abraham Lincoln, or Andrew Carnegie.  Even leaders who began their lives in relative privilege, such as George Washington or John F. Kennedy, still have their narratives told from the perspective of their individualism, emphasizing their leadership as ahead of the curve, or visionary, and attributable to their own character.

Horatio Alger became one of the best selling authors of the 19th century peddling stories of the rugged individualist who starts from nothing and makes it big.  Individualism has as the following assumptions:

–Community is built up by collecting worthy individuals.

–Social structures are a hierarchy or “ladder” one must climb

–Success or failure is a result of an individual’s actions (work ethic)

–Ambition is a positive character trait.

By contrast, today’s “millennial generation”, the first to be immersed in social media full time, have completely different assumptions. For them, to be in community is the default:  hence you see very little desire to join long standing traditional communities, such as the military or the clergy, especially if these require personal sacrifice or long term commitment.

Members of this generation are trying to “find themselves” not make their careers.

Instead of the traditional assumptions of American individualism, you find these assumptions:

–I will opt in and out of the communities I belong to

–The best organizations and structures are flat

–Individuals are products of their environment and have little self-determination

–Ambitious people are bad

Anecdotally, you see things from this generation valuing the “four hour work week”, or preferring flex time over career promotion from an employer. This generation has strong preferences for

–self-expression over appreciation of the great works of others (poetry has ceased to exist).

–gaining experiences over acquiring things.

The main reason for this new set of assumptions is the shift from an internal standard (such as guilt or shame) to an external standard.  Individualism has people looking inward to their own sense of right and wrong, their personal aspirations, etc.  Social media by their very essence have individuals looking outward, to their peers, for external validation of their actions and views.

The dynamic has shifted from being the individual who goes out to establish himself in the community and in the world to being people already in community through social media with others globally who need to “find themselves” as individuals.  Narcissism is the logical extreme of this, which cannot exist in individualism which emphasizes becoming self-made, as judged by external standards.

American individualism cannot survive in this culture except as a relic of history or in small minorities who opt out of the mainstream.

** The “Non-Obvious Dinner” is an annual event hosted by Ben duPont, Jeff Rollins, Henry Mellon, and Mike Kane in Wilmington, DE.  Each guest presents a two minute argument for a trend that is currently not obvious but will become so over the next five years.  The presenter with the best idea of the evening gets bragging rights, promises of major book advances, and a metal award difficult to take through airport security.

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How to Answer Google’s Interview Questions

The key to a successful interview with Google is not answering the question, which is so yesterday, but challenging the question’s validity, which shows independence of thought.  Take these exchanges for example.

Question: “You are shrunk to the height of a nickel and your mass is proportionally reduced so as to maintain your original density. You are then thrown into an empty glass blender. The blades will start moving in 60 seconds. What do you do?”

Answer: I would organize a protest movement where hundreds of others who have also been marginalized and diminished by society come together to occupy the bottom of the blender.  So many of us would cluster there the blades could not move. There is strength in numbers.

Question: “How would you find out if a machine’s stack grows up or down in memory?”

Answer: I think the question is intrusive and would never violate the machine’s privacy in this manner.

Question: “Why are manhole covers round?”

Answer: Natural selection.  Other phenotypes representing different shapes used to exist but failed to survive due to predation and other environmental forces.

Question: Explain a database in three sentences to your eight-year-old nephew.

Answer: I don’t have an eight-year old nephew.  There is no such thing as a database.  What is the next question?

Question: How many gas stations would you say there are in the United States?

Answer: The correct answer—which has nothing to do with what “I would say”—is that the number is unknowable.  The number of places to get gas would need to include Mexican restaurants.  These establishments come and go at rate so fast by the time you finish counting, the number changes.  Heisenberg knew this.

Question: How would you design analog filters?

Answer: I wouldn’t. If that’s part of the job description, you’ve got the wrong guy.

Question: Given inorder and preorder traversals of a tree, reconstruct the tree.

Answer: Only God can make a tree.

With answers like these, you’re sure to be in like Flynn.

Mike Kane  mkane4811 “at”

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Swedish Fish are Made in Canada: And Other Realizations of a Slow Learner

The mother of a dear friend was the most superstitious person I ever knew.  She carried a large number of crazy notions with her right up to her death from a bolt of lightning after inadvertently walking under a ladder to avoid a black cat that happened on her path.

One of her beliefs was that the mood you have on New Year’s Eve will be the dominant mood in the coming year.  With that in mind, I have decided to write a little light humor (many will say, very light humor) on some late realizations of my still evolving brain.

My 8 year-old daughter started telling me the other day about the rules for adding negative numbers.  That made me realize that I was probably in 5th or 6th grade before first encountering negative numbers, whose existence I, being an Aristotelian realist from an early age, resisted for a long time.  I could get the “You have 3 applies and give away 2” part.  But I had trouble with the concept of negative apples. (I did not then appreciate then how prominently negative numbers would figure in venture capital.)

I have been late to some other realizations, as the following table shows:


Popcorn comes from corn                                                                                 8

Pickles are made from cucumbers                                                                  17

Plastic is made from petroleum                                                                       19

A 2×4 is really 1-1/2″ x 3-1/2                                                                            20

Raisins are made from grapes                                                                          21
Ulysses Grant and WC Fields had a drinking problem                                                                    24

GrapeNuts is made from sawdust                                                                    26

There are no minorities in the classic Frosty the Snowman movie                                                                                                                      38

Big Bird is a boy (I think)                                                                                    40

Surgical gloves and paint are made of the same stuff                              Recently

Hawaii is “5-0” because it’s the 50th state                                                   Not disclosed

Methane is produced by trees decomposing without oxygen                 Last Tuesday

The one realization in my entire life where I was ahead of the curve, whatever that means, has to do with Santa Claus.

READER CAUTION: Certain statements about Santa Claus that may potentially be offensive follow.  You may wish to stop reading here. If you’ve read this far already, that’s your own damn fault.

Leading up to the Christmas just before my 5th birthday, I began to wonder about the supply chain complexity of one guy delivering presents to children worldwide in a single 12 hour shift.  It occurred to my developing mind that if it took my mother over an hour to buy groceries for our happy family, there’s no way an old guy like St. Nick could get all that work done overnight, even adjusting for time zones.  I hid behind the couch that Christmas Eve to test the hypothesis.  (I was also early to the scientific method).  When I saw my folks delivering presents from “Santa”, the gig was up.  The short duration of the Santa belief is probably at the root of many of my current neuroses.

What the above realizations show above all else is the excessive amounts of time I seem to have to be writing this blog, and the poor use to which I have put that time.

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What Immanuel Kant Taught Me About Venture Investing

By far the greatest challenge for any VC is picking the right company to invest in and backing the right management.  I have tried to improve the likelihood of success here using something I learned from the philosophy of Immanuel Kant.

There are some figures who completely embody in their thought the spirit of their age. Leibniz and Bishop Berkeley come to mind here.  Then there are a very few whose thought changes the course of intellectual history.  Kant is clearly in the latter camp, along with Descartes and Aristotle.

Kant (1724-1804) was a German thinker who altered the course of modern philosophy in three major works published between 1781 and 1790.  The first and most important of these works, the Critique of Pure Reason, represents what Kant called his “Copernican Revolution”.  Nicolas Copernicus speculated in 1543 that it may be the earth which is in motion around the sun, and not the other way around.  Kant applies this idea of our activity to the theory of knowledge, which the philosophers call “epistemology”.  Reacting to the view of the British empiricists, such as David Hume and John Locke, who thought the mind was a tabula rasa or entirely blank slate until experiences formed it, Kant asked a deeper question:  How would it even be possible for an entirely empty mind to have experiences which could imprint themselves to form basic concepts in the mind such as cause and effect?

In asking this, Kant is doing “transcendental philosophy”.  The word transcendental in Kant’s usage has nothing to do with transcendence, and the later Transcendental movement of Emerson and Thoreau has no connection to Kant. Instead, transcendental means “concerned with the conditions that make something possible”.  In the First Critique, Kant asks, what conditions are needed to make knowledge possible?  Before answering the question of what we know, it’s important to wonder how knowledge is even possible. I will skip over a detailed account of Kant’s fascinating answer to the question, and mention only one insight by way of an example. In order to process experiences, the mind must a priori— i.e. prior to experience–have the notion of time.  Otherwise we could not say that some experiences happened first and were followed by others.

It’s in this practice of asking transcendental questions that I’d say Kant has taught me about venture.  Every single deal I see seems to present a “disruptive” technology. They all have successful experienced management teams, massive addressable markets, etc.  A good old-fashioned diligence process of kicking the tires and testing assumptions will yield valuable intelligence here. But I have found it helpful to ask questions about what the transcendental conditions for the start-up’s success are.  What has to happen for a product or service actually to disrupt its market?  What are the conditions that must obtain for a customer to need the product, versus merely wanting it?  Raising this line of inquiry has yielded some helpful filters in our diligence process.  For instance, everyone tries to understand what the company’s sales pitch to the potential customer sounds like. We then ask how the conversation runs which the pitched executive initiates with his or her boss within the organization. (Most entrepreneurs don’t initially get into a meeting with the final decision maker). It’s nearly impossible for the person pitched to become a champion for the start-up if the product is seen as “nice to have if we had an unlimited budget”. What has to happen for that person to take career risk in advocating for the start-up’s solution?  What are the conditions necessary for the start-up’s competitive position to remain or grow stronger over time?  What would keep the competitors from answering with a crushing response?  What new things does the leadership team need to learn if the company grows substantially?  Under what circumstances do failure points become relevant?  Asking these kinds of questions is really a form of inquiring into the transcendental conditions of the company’s success, a way of thinking I first encountered in the philosophy of Immanuel Kant.

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How to Get a Cab In New York City

How to Get a Cab In New York City

Correspondents from across the country write in asking my advice on everything from struggling relationships to synthetic roofing materials.  A common request concerns the process–often perplexing to tourists—of getting a cab in New York City. I am only too glad to help with the following.

Some History New York was originally called New Amsterdam.  The name was shortened to New York because “York” is shorter than “Amsterdam”, but that’s neither here nor there.

Getting a Cab The most important piece of advice I have here is to hide your luggage from the driver’s view.  A cabbie who sees a suitcase involuntarily imagines a neon sign saying “JFK Airport”.  The only thing your cabbie fears more than deportation is taking a passenger to JFK.

Another trick that has served me well is to avoid the major thoroughfares when trying to hail a cab.  Say you’ve just seen a Broadway show, which for two straight hours impressed you with the shocking lack of originality of the Great White Way.  Coming out of the theaters into Times Square will be thousands of people all vying for the same twelve cabs.  You don’t have to be Fermat to see that the probabilities here are not good.  What I do in this circumstance is to loosen the collar of my shirt and take a determined hike into Hell’s Kitchen.  By about 10th Avenue uptown of say 53rd Street, a ready supply of available cabs opens up.

This strategy has health benefits as well.  Whenever I come back from an extended stay in the City, people often comment on how hale and fit I look, which I attribute to the 7-8 miles a day I walk in dress Oxfords while trying to get a taxi.

Giving Your Destination Many tourists, wanting to appear street savvy, wonder if the local syntax is to say “42nd Street and Seventh Avenue” or “Seventh Avenue and 42nd Street”.  By the commutative property of addition, which you should really know by this point in your life, the order of numbers for streets and avenues does not matter.  You should however avoid vague instructions like “Go North” or “Just start driving and I will tell you when”.  The cabbie will fear this is a trick to get you to JFK (see above) and will respond in kind by running into McCleary’s Pub “just for a minute”.

Dealing with Fear Do not be filled with dread like most first-time riders or many life-long riders.  I find the following reflection helpful.  Your driver is a professional who has had many, many more serious accidents than the one you’re afraid of at any given instant.  His credentials include having completed the arcane paperwork required by the City and being able to spell “medallion” correctly seven out of ten times.

Proper Etiquette Beyond giving your destination, you should say very little to the driver.  Here I take issue with the typical guide books, most of which were written by authors who have never been to New York.  What little they know about taking a taxi was gleaned from poorly dubbed reruns of the original Bob Newhart Show, which incidentally was set in Chicago and shot entirely with indoor scenes.

As a result, the standard guide book has advice like:  “Make friends with the driver.  After all, he is the real New York.”  “Invest some time before your trip in learning a little Northern Khmer dialect.  This will go a long way with the taxi driver.”  “Learn as much as you can about politics in the Dominican Republic.”

All this advice is bad.  You’re much better off not talking to the driver beyond the bare minimum.  While pretending to pay attention to traffic, he’s actually calling into a luxury condominium auction in Miami.  And remember that you’re a guest in his cab.  His cell call is much more important to him than yours is.

A Recent Example Here is a transcript of the last taxi ride I took which may serve as a model for the enlightened tourist.  (A shorter version may be used by omitting the section in brackets at the discretion of the local bishop.)

Me:  55th and Fifth please.

Driver:  Fifth or First?

Me:  Fifth.

At this point, the driver resumed the call the earlier dialogue had interrupted. Shortly thereafter, my cell phone rang.

[Me:  There’s no way the Series A will be fully subscribed under those terms.

Driver: U ovom sam trenutku toliko uzbuđena zbog prilike koja mi se pružila da nemam vremena razmišljati .

Me:  All the incentives here are for the lead to run the clock.

Driver (now raising his voice): O onome što će biti sutra!!

Me:  There would need to be some preference in the waterfall.

Driver (now shouting and pumping the brakes) VELIKIM DIJELOM ZASLUZNI GOTOPRIMLJIVI I VESELI !!!!]

Me (seeing the meter and having reached the destination):  Make it $14

Driver:  Thanksa You.

Conclusion The above may not be of much help to you in getting a cab, but it will at least give you something to read on the subway besides those dreadful guide books.

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Plato and the Timing of the Jobs Speech

Reading commentary on the timing of the President’s awaited “jobs speech” to Congress has been a pleasant diversion from the earthquakes, hurricanes, and plagues of locusts which have marked our recent weather in the Northeast.  The President initially intended to deliver the address on September 7th but agreed to move it to the 8th since the 7th was the date of a long-scheduled Republican primary debate.

From the right, the commentary runs something like this:  It is political theater to have a president pre-empt the debate by candidates who seek to unseat him, especially when the date of their debate was well-known.  It is already enough to bear that a special joint session of Congress has been called for what is essentially a political event in the president’s re-election bid.

From the left, the good word runs like this:  Never in our history has a president’s request to address Congress been treated this way.  The purely political nature of the Republican debate is clearly trumped by the business of government in responding to the economic crisis we face.

In this piece, I do not intend to side with either argument above, though for me listening to a politician talk about creating jobs is like hearing a starfish talk about creating tidal waves.  Instead, I want to use the present case to illustrate Plato’s view of knowledge.

The most telling feature of each argument above is its reasonableness.  Both sides present credible arguments.  And that, for Plato, is the problem, because what we get in these arguments is pure opinion, always subject to change and never subject to universal consensus.  If party affiliations were reversed, and a Republican president created a conflict with a Democratic debate, the very people arguing for accommodation by Congress today would be making the case their opponents are presenting for re-scheduling to accommodate the debate.

The issue this highlights is that opinions, however reasonable on their surface, tell us nothing about the real world but only serve to reveal the prejudices of their holders.  Plato thought that the social, political, and for most of his life, the natural, worlds did not admit of true knowledge but rather only of opinions.  These realms do not present the essences of things but only mere shadows.  In the famous Cave Allegory, the residents are literally seeing shadows of objects from the outside, real world, but not accepting that world’s existence, award each other prizes for best recognition of the shadows they mistake for reality.

But shadows need to be shadows of something, and here Plato’s complex “Theory of Forms” comes into relevance.  In the physical and social worlds, we see copies of the true essences of things.  To get to knowledge, we need to see the essences themselves.

Knowledge, unlike opinion, is objective and mathematical in its character:  there are not multiple reasonable answers to questions.  Instead, there is one answer, which tells us nothing about the questioner, but only about reality, and which is not subject to change.  The physical world never presents the essence, only the copies.  We never see “Three”, but rather three branches of government, or three day weekends, or three blind mice.

In a trial, the judge seeks the just outcome.  In order to get to this, he must know the essence of Justice itself.  We recognize multiple shades of white as white because we have some intuitive grasp of Whiteness itself.  But to know those essences, especially to know the important ones such as Justice, takes special training, the rigorous application of intellectual gifts, and a renunciation of the allure of material things.

Few people are gifted enough to do this hard work, so for Plato the idea of democracy is repugnant.  In his Republic, he compares it to a drunken crew with no knowledge of navigation taking control of the ship due to the strength of their numbers.  We would never take a vote of the passengers on how to operate a complex system such as a ship, but we do just that when it comes to the more complex, and infinitely more important, realm of our lives together in civil society.

The few who are so inclined must be nurtured from their earliest childhood.  They will be shaped and tested, and the very few who pass will become the rulers of the society.  It is wrong to name them “philosopher kings” for a couple of reasons.  One is that they’re not kings at all, but rather servants of the people.  They live in ascetic conditions and are paid nothing. Plato also allowed that some of the leaders will be women, a radical notion in the 5th Century BC.  If a just society requires a knowledge of the essence of Justice itself, then we need to let those possessing that knowledge also possess political power.

There are very many problems with the solution offered in Plato’s Republic, the most damning of which for me is the lack of liberty individuals have over their own lives.  Churchill’s famous line about democracy comes to mind:  it’s the worst form of government except for all the others.  But the circumstances of the coming jobs speech, with its widely divergent opinions, and the failure of the press to present factual information instead of even more opinion, reminds me of the same problems Plato is trying to resolve more than two thousand years ago.

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Why Pay to Play is Bad for Venture

Why Pay to Play is Unfair to Angel Investors and Bad for Venture Overall

“Pay to play” in venture term sheets should have the same deservedly bad reputation as it does in government contracting, where it is illegal.  In this piece, I will present three arguments against pay to play.

By way of background, “pay to play” provisions in a term sheet are a mechanism to induce existing investors in a company to invest additional capital into the company.  This is accomplished by punitive treatment of the existing investment should the investor want or need to sit out the current round.  Typically, this treatment includes forced conversion of a preferred security into common stock, as well as some other common measures to change the rights and value of the prior investment.

Argument 1: The first problem I see with pay to play is the moral hazard it creates for bad management.  This point is a combination of observation and behavioral theory.  Observationally, I have never seen pay to play terms in a company where management has done an exceptional job.  While every venture company produces forecasts that don’t pan out, pay to play allows especially poor managers to elevate their errors to a higher art.  In one recent example I saw, the portfolio company’s management awarded themselves large salaries, while they oversaw the destructions of millions of dollars of cash from the comfort of their Class A offices in an expensive leafy suburb.  When they were close to running out of cash, they simply asked the lead investor to issue a term sheet for a follow on round where the prior investors, in the company less than 12 months, had to participate or be crushed.  Pay to play in a term sheet is an indicator of poor cash management skills in the management team, in the same way that dizziness is an indicator of inner ear problems in a patient.

This brings me to the behavioral component.  One of the dearly bought lessons of the 2008 financial crisis concerns the moral hazard created by providing a risk backstop to people who should otherwise be managing risk.  The lender of last resort assurance allows irresponsible behavior since the management never confronts the reality of failure head on.  In the case of Lehman Brothers, senior management was adding risk the week the firm failed, all due to the belief in a government backstop.  In the case of venture companies, husbanding the cash and slowing down the burn are simply less urgent tasks when senior management knows they can go back to prior investors with punitive pay to play terms to raise additional capital as needed, which is usually justified by describing this as a “small raise”.

Argument 2: Pay to play always seems to me to have a weird moral dimension to it, whereby participating investors mete out punishment to those investors who want to sit out this round for their reprehensible behavior.  This of course assumes an existing investor does not participate due to a negative verdict on the company.  In reality, there are often several reasons why prior investors cannot fund again in this round.  Chief among these reasons are the capital constraints on the prior investors, which is especially true for angels.

Instead of punishing the early investors, why don’t the current investors simply strike the deal they want with the company in a fair negotiation?  There is no need to re-write the terms of some early angel investors just because they lack a fund with reserves for follow-on financings.  Why not just let the market function? It would be normal for you to receive a security senior to the existing preferred, without forcibly converting that to common.  This brings me to my final argument.

Argument 3: Pay to play is inherently unfair as it retroactively and unilaterally changes deal terms for those investors who have performed their responsibilities and who have borne the most risk.

Imagine a landlord who rents out a house at the beach by the week.  Now suppose that you rented it for a week during the last non-peak week of the season, and only intended to stay six days.  Now I come along as I am booking my stay, and say this proves you’re not a good renter from this landlord.  I am paying peak prices and staying all seven nights.  Therefore, you should be downgraded to a cheap motel somewhere far from the sand.  Doesn’t it seem strange that the economics of my deal should rewrite the terms of your rental unilaterally?

I am sure there are problems with that analogy, one of which is that venture is no day at the beach.  But it at least illustrates , I hope, the retroactive rewrite of contracted terms, without allowing the earlier party into the negotiations.

Pay to play is unfair since it is the management—not the prior investors–who have failed, for reasons legitimate or not, to meet the forecasts. Yet it is largely the earlier investors who bear the costs when the terms of their investment are rewritten without their consent.

I hasten to add that pay to play is different from re-pricing the securities.  Pricing is done by the market and done imperfectly.  It often happens that an asset becomes worth less than what one paid.  That re-pricing is a normal function of the market.  What I am arguing against is the change in the terms of the deal, adjusted unilaterally and retroactively by one lead investors over and against prior investors.

When VC smugly insert pay to play language into term sheets, do they stop to think how much this poisons the well for early investors, especially angels?  When I was launching Fairbridge Ventures, one of our first potential deals had a respected and sophisticated angel group from New England.  As I was unknown to them, as I am to most decent people, their lead on this deal kept peppering me with questions about how I treat early investors, how I think about angels and the risks they take, etc.  I eventually decoded his questions enough to say:  “If you’re asking about pay to play, I think it’s unfair and borderline unethical”.  At that point, he reported back to his peers that Fairbridge was a reliable co-investor.

If VCs were self-interested in an enlightened way, they would advocate for anything that encouraged robust activity by angels, and swear off anything that visited on angels punishment for the sins of others.  Pay to play simply poisons the well for angel investors, who are a vital part of the venture ecosystem, whose early vision, risk-taking, and hard work should be recognized and respected.

Mike Kane

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