Risk Architecture and Financial Innovation

High Yield Value Investing in Start-Up Enterprise

Thomas Hu 胡一天胡一天胡一天胡一天

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October 2013

Table of Contents

� Goal Architecture and Financial Engineering

� Risk Monetization in Start-up Investing

� Mezzanine Capital for Entrepreneurship

� Endowment Model and Memory Financialization

� Questions & Answers

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Goal Architecture & Financial Engineering

“Finance is the science of goal architecture.” ~ Finance and the Good Society, Robert Schiller

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Financial Technologies Provide Tools for Goal Architecture

� Modern financial system is a complex web of contracts whereby participants with asymmetricinformation engage in trading activities in order to maximize expected cash profit.

� The emergence of Internet technologies has greatly reduced the cost of democratizing,humanizing and expanding the reach of financial capitalism on a global scale.

� Financial technology is designed to facilitate the goal of individuals, companies and societies.� It is a means to an end, not the other way around. (the Latin root for finance is finis, i.e., end)� Financial service industry should principally focus on perfecting its goal facilitation capability,

not self-serving wealth privatization by exploitive practices.� A feasible goal architecture is built on common-sense risk management system.

� Finance is amoral.� Guns don’t kill; People kill.� Pervasive chronic problems in financial capitalism are usually not due to lack of control over

financial instruments, but lack of control over incentives to regulate sustainable behaviors offinancial professionals.

� Unfortunately, the goals and ideals of a civil society are sometimes underserved by the self-serving financial industry, resulting in wide-spread criticism.

� Is venture capital model still relevant?� It’s less about liquidity crunch but more about expectation shortfall.� Engineering optionality and value creation via good deal design.� Start-up incubator program as an asset class for institutional investors?

� We need a new definition of generalized investment yield.� Capital allocation model in broader social context?� Epidemic psychology and physiology may be more relevant than neo-classical economics.

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Risk Monetization in Start-up Investing

“Entrepreneurship is a risky and heroic activity, necessary for growth or even the mere survival of the economy.” ~ Antifragile, Nassim N. Taleb

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� Investing in a start-up, or any firm at different development phase, requires deep research on therisk and return profile of the underlying business process employed by the firm to generate profit.

� For firms competing in the same business environment, the true valuation metrics that differentiatethem are the firm’s distribution policy and investment strategy with respect to its free cash flow.There are only five options a firm can do with its free cash flow:

� Pay cash dividends;� Repurchase outstanding shares;� Repay outstanding debts;� Mergers & acquisitions;� Reinvest in internal projects with expected return above its cost of capital.

� Major challenges in start-up investing include uncertainty of cash inflow, low frequency of cashinflow, alarming magnitude of cash outflow, unproven management capability, lack of liquidityand expectation shortfall on exit venues.

� Take a mirror image of a left-skewed probability distribution below, it is immediately obvious thatentrepreneurship in business models unfamiliar to venture capitalists is unfairly discouraged andpenalized due to lack of observed rare events of success.

� The symmetry of “Black Swan.”� Due diligence for the known unknowns and unknowable unknowns.� How to manage rare event risks on fat tail?� Super Angels come to the rescue?

� We need a market specifically designed for seeding start-up firms.� Focus on business development & risk management;� “Invest-and-Operate” vs. “Pump-and-Dump”� Innovation in monetizing risk factors.

Risk Monetization for Start-up Investing

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Unseen rare events

Convexity Risk Management in Start-up Value Creation

� In general, successful investment involves proactive management of convexity and optionality.� Business and investment decisions should focus on contingent payoff skewed to the upside.

� Admitting uncertainty and unpredictability in the evolution of X, we should focus on controlling the

exposure to favorable outcome of f(X), as a convex f(·) can have fatter tail with the right skew.� Example: risk/return profile of an portfolio of call options on X’s vs. a portfolio of X’s� Street-smart common sense is more important than economics and statistics.

� Value creation in start-up investing is about fostering an environment conducive to positive convexity andasymmetric payoff optionality that may bring about exponential growth with increasing probability.

� What if you are caught in a concave situation?

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Jensen’s Inequality: φ(E[X]) <= E[φ(X)]

The Illusion of Control & Rare Event Response Mechanism

� The Illusion of control and uninformed optimism are pervasive in the linear world with slow andinfrequent changes, i.e., path-dependent perception.

� Inverse Turkey Problem is a scalable phenomenon in the non-linear world with acceleratingfrequent changes that are unpredictable and potentially unavoidable.

� Informed pessimism and expected shortfall are as common in early-stage investing as in advancedfundamental R&D.

� Systematic redundancy in risk management mentality is needed to utilize scarce resources.

� Is it possible to buy an insurance policy designed to mitigate such a risk?� How much would you have to pay?

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Source: The Black Swan (N. Taleb 2007/2010)

The Inverse Turkey Problem

Change in life expectancy of a turkey in the Thanksgiving morning, or the expected success rate of a start-up upon informed pessimism?

Not seeing the cliff ahead, a naive assessment of historical experience may lead you to believe that uptrend will continue…

Optimal Error Margin & Pivot Duration

� Margin of error is absolutely essential to investing as mistakes are inevitable in any ventures.

� Time is the most precious scarce resource for a start-up enterprise. Lean Start-up philosophy is similar tominimizing the duration required for a pivot attempt before finding a Minimum Viable Product (“MVP”).

� Experience of super angels may help start-up entrepreneurs become agile, shrewd and efficient.� Proactive risk management is about common sense, business acumen and intellectual honesty.

� A more rigorous approach to analyze the risk and return profile of Super Angel venture capitalinvestment process is a crucial step in increasing the attraction of start-up incubation programas an investable asset class.

� Is there a set of “Moneyball” formula to systematically identify, train and maximize thewinning odds of a team of entrepreneurial talents?

� Would constructing a portfolio of incubators and accelerators programs be a scalablestrategy to gain diversified exposure to start-up investments? (e.g. an incubator REIT?)

� Yield to MVP instead of IRR?

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Mezzanine Capital for Entrepreneurship

“We can unwind all our flaws.” ~ Mezzanine, Massive Attack (1998 album)

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Deal Design for Promoting Entrepreneurship

� Enterprise valuation mismatch reflects differences in opinions between entrepreneurs and investors withregard to timing, certainty and magnitude of revenue and cash flow realization.

� Investors usually heavily discount unrealized future events despite passion/dedication/capabilityof a start-up entrepreneur.

� Discount factor is best viewed as a dynamic negotiation process.

� A successful deal design is mutually beneficiary, as venture capitalists and entrepreneurs are all part of asymbiotic ecosystem aiming at attaining sustainable deal flows in the long run.

� Most importantly, a good deal designer recognizes the real driver for an investment success is thesustainable performance of the underlying business, and will structure a deal appropriately topromote and protect the operating process and behaviors of business operators which createsuch a success.

� A good deal design acknowledges that entrepreneurs and investors need to agree to disagree onmeasurable key performance metrics at each pivot milestone.

� Getting the business model right is more important than getting the valuation right.� “Trust the Captain, trust the crew.”� Buying the wrong target is worse than buying an expensive target.

� Each business model has different capital needs at different development stage.� Plain-vanilla investment structures such as pure equity and pure debt may not always be suitable

for a start-up during fast prototyping phase.� A more precise and flexible staged financing solution in investment structure is required.

� Structuring incentives mechanism with positive convexity and embedded optionality with long durationencourages “skin-in-the-game” behaviors. For instance, earn-outs, cumulative participation preferredequity and RSU to drive sustainable behaviors instead of short-term gamesmanship.

� Good deal design reduces dependency on “liquidity events” (e.g., IPO/trade sales) for exit.

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Risk Profile at Various Attachment Points in Capital Structure

� Capital formation for a start-up requires more precise selection of risk attachment point in capitalstructure as entrepreneurs going through different phases of business development.

� Operating constraints and institutional memory tend to limit pure debt/equity capital providers’ riskappetite and ability to fine-tune risk exposure in start-up investing.

� Mezzanine capital providers may fill the vacuum.

� The pros & cons of using a mezzanine financing facility in start-up/growth capital investing are:� Pros: limited or no ownership dilution, flexible payoff structure, finite duration, etc…

� Cons: debt or quasi-debt repayment schedule may create liquidity gap for a lean start-up .

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Senior Stretch Mezzanine EquitySecurity Secured Partial Subordinated none

Ranking Senior First on Assets Second Third

Covenants Tight Tight Flexible none

Term Demand Term Term / Patient Patient

Coupon Coupon - Floating Coupon - Fixed Coupon - Fixed Dividend

Rate Prime Prime Adjusted Risk Adjusted Market Adjusted

Equity Kicker none Success Fee Warrants Shares

Prepayment Penalties

Yes Yes Fixed Period No

Capital Providers Chartered BankChartered Bank / secondary lender

Private Capital Private Capital

Recovery % High medium Low Low

Liquidity High medium LowRight of Sale / Shotgun

Source: FitchRating

Mezzanine Capital Provides Flexibility Across Capital Structure

� The basic structures used in most mezzanine financings are subordinated debt and preferred stock.

� Typical contractual return profile may include the following bespoke payoff terms:� Cash interest: A periodic cash coupon as a percentage (fixed or floating rate) of the

outstanding balance of the mezzanine financing.� Payment-in-kind (“PIK”) interest: A periodic form of payment in which the interest payment is

not paid in cash but rather by increasing the principal amount of the security in the amount ofthe interest

� Ownership: An equity stake in the form of attached warrants or a conversion feature, similar tothat of a convertible bond.

� Participation payout: An equity-like return in the form of a percentage of the company’sperformance, as measured by total sales, or EBITDA as a measure of cash flow, or profits.

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SENIOR SUBORDINATED DEBT

CONVERTIBLE SUBORDINATED DEBT

REDEEMABLE PREFERRED STOCK

EQUITY

MEZZANINEMEZZANINE

SENIOR DEBT & ASSET BACKED (STRETCH) LENDING

Source: FitchRating

� Target IRR: 15 ~ 20% � Lower risk than pure equity,

higher return than pure debt� More structural flexibility in

supporting business needs.

Case Study: Financing an Innovative Architecture Studio

� Investment Thesis: The architecture landscape in Taiwan has seen continuous erosion in designinnovation and social context awareness. Heightened land acquisition cost and pressing needs forurban renewal call for a new enterprise in promoting better architectural products and sustainabledesign philosophy that simplifies our life and enriches our minds.

� Risk Factors:� Highly sensitive to the “boom and bust” of real estate cycles.� Lack of established client base and proven customer acquisition channels.� Weak bargaining power against big property developers and inability to protect margin.� Constant needs for short-term working capital as development speed varies across projects.� Key Man Risk and insufficient scalability.

� Structuring Solutions:� Focus on brand-building, project selection and ASP upgrade.� Cash burn rate control to ensure the business is well capitalized.� Build a balanced order book of interior design projects as well as large residential/commercial

construction projects .� Design project receivables financing to support working capital needs.� Revenue off-take mechanism structured as special cash dividend for seed capital de-risking.� Diversifying into industrial design and social media?

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Case Study: Investing in a Predictive Analytics Start-up

� Investment Thesis: The exponential growth in Big Data due to mobile Internet and ubiquitous smartdevices has substantially reduced the cost of information access and retrieval. Amid rising flood ofunstructured data, business intelligence platforms must stay viable by providing relevant analytics formaking robust business judgment on predicting and inducing customer behaviors in order to createfinal demand. Existing bureaucracy in large organizations is oftentimes incapable of cultivating sucha team of talents with sufficient speed and error tolerance mindset.

� Risk Factor:� Too much focus on disruptive technology instead of disruptive business model that solve real-

world problems.� “University lab” mentality is not suitable to the suffocating speed in the high-tech race against

time to market.� A good hacker is not necessarily a good CEO.� Big Brothers (e.g., GOOG/AMZN/FB/QQ) are watching!

� Structuring Solutions:� Covenants on maximal pivot duration and cash burn rate control.� Limitations on excess headcount expansion during pivot iteration phase.� Recruit non-technical Super Angels/advisors with entrepreneurial track records.� Staged equity/quasi-equity investment schedule based on MVP milestones.� Switchable debt/equity conversion features in structuring mezzanine facility.

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Case Study: Crowd-funding a Lifestyle Social Media Hub

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� Investment Thesis: Increasing adoption of the social layer by web publishers has enabled socialmedia to become focal points in directing traffic around the Internet. Ubiquitous access to mobileInternet via smart devices allow users to focus only on activities in their social circles and localcommunities. Social media account for a increasingly larger share of audience attention span anddesynchronize consumer response to advertising cues. Advertisers can leverage on the inherent trustin consumers’ social circles and launch targeted marketing campaign with the help of lifestyle socialmedia hub with sticky user traffics.

� Risk Factor:� Fragmented media consumption channels provide insufficient evidence to attract advertising

budget allocation.� Dependency on “civil journalists/writers/bloggers with limited coverage density and editorial

consistency.� Political, ideological and cultural barriers may significantly curtail scalability and adverstising

revenue intake.� Lack of alternative source of cash flow via recurring pay wall subscriptions.

� Structuring Solutions:� Invest in story generators and opinion leaders that can build a lifestyle brand� Proven capability in high-quality contents origination and production before investing

commitment.� Recruit independent writers and editors capable of in-depth investigative journalism with

regional perspectives.� Cross-fertilization between financial media platform, research consultancy and public

relations advisory firms to create recurring demand and promote mindshare.� Earn-out structure based on revenue/EBITDA off-take for key content contributors before

equity investors.� University endowment funds as strategic investors?

Endowment Model & Memory Financialization

“Money is equivalent to a primitive form of memory.” ~Journal of Economic Theory 81, 232-251, N.R. Kocherlakota

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Endowment Fund Investment Model Revisited

� Modern portfolio theory postulates that each asset class has a measurable historical return, volatilityand correlation profile that can be optimized to construct a diversified investment portfolio withreduced risk and enhanced return versus a broad market index.

� The Five Principles of the Yale Model (David Swensen 2009):� Invest in equities, it is better to be an owner rather than a lender;� Hold a diversified portfolio, avoid market-timing and adjust allocation at extreme valuations;� Invest in illiquid private markets with incomplete information to increase long-term returns;� Use outside managers except for all but the most routine or indexed investments;� Allocate capital to investment firms owned and managed by investment professionals to

reduce conflicts of interest.

� Guided by the above philosophy, Endowment Model heavily invests in equity and alternative assetclasses (e.g., hedge fund/private equity/real estate) and has generated outstanding results:

� For the 10 years ending June 30th 2008, Yale Endowment produced an annual return of 16.3%vs. 2.9% of S&P 500.

� During this period the AUM of Yale endowment grew to US$23 billion from US$6.6 billion.� About 38% of Yale University’s operating budget is financed by the Yale endowment.

� The Global Financial Crisis of 2008-09 dealt a heavy blow to endowment model due to hiddenleverage, systemic illiquidity and the convergence of downside correlation across asset classes.

� Extreme Value Theory (“Black Swan”) is more relevant than CAPM in a fat-tailed world.� However, endowment funds continue to hold their course…

� Is Venture Capital still a relevant investment strategy for university endowment funds?� Duration mismatch vs. Expectation shortfall.

� Can crowd-funding finance a social endowment fund which allocates capital to start-up firms?

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Memory Financialization for Future Generations

� The fundamental innovation of financial system since the dawn of human civilization is themonetization of memory in various forms of transferrable credit.

� Fiat currencies, stock, bonds, real estate and virtual payment gateway are all memories ofpast deeds crystalized by financial technology.

� Memory is the source of credit which facilitates resource transfer across time and space.� This observation has profound implication for start-up fund-raising strategy.

� Capital allocation decision should not be based solely on statistical construct of reality, least of all onbureaucratic fantasy. We need incentives systems and regulatory mechanisms that administer painsand rewards based on memories of what happened and/or may happen in the real world.

� In broader social context, an independent logic & memory network which checks and balancescollective intelligence may be the crucial component of a more adaptable investment process thatpromotes “the greater good.”

� Toward a new paradigm of generalized yield of investment:� High yield investing is not just about profit maximization.� From Behavioral Finance to Epidemic Psychology to Financial Physiology.� Progressive Entrepreneurial Darwinism vs. Regressive Predatory Capitalism� Institutional Trust: Lost & Found?

� A shrine of entrepreneurial martyrdom?� Doing start-up should never be a social stigma. � Just Do It!� Praise the failure and bury the success. � 失敗為成功之母失敗為成功之母失敗為成功之母失敗為成功之母!

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“Hegel remarks somewhere that all great world-historic facts and personages appear,

so to speak, twice. He forgot to add: the first time as tragedy, the second time as farce.”

~ The Eighteenth Brumaire of Louis Bonaparte, Karl Max (1852)

Questions & Answers

“To be, or not to be, that is the question.” ~ Hamlet, William Shakespeare

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