ExOne IPO Successful: Shareholders Contribute Random Passers-by

Before I start bashing bankers, I’d like to congratulate the ExOne Company on a successful initial public offering (IPO).  I haven’t seen much about ExOne [NASDAQ:XONE] on the robotics sites, but if we’re calling Stratasys [NASDAQ:SSYS] a robotics company, we should call ExOne a robotics company as well.  It is really good to see another public company in our sector.  Hopefully, this will encourage more investment of both capital and entrepreneurial energy in our industry.

Last time I checked 26 is a lot more than 18.

Last time I checked 26 is a lot more than 18.

By the criteria of the market commentators, the ExOne IPO was a huge success.  You can Google things like “3D printing red hot.”  The IPO was priced at the top of the range $16-18, it opened around $26 before shooting up over $33.  Almost a week later it is trading roughly at its opening price.

Now this is all fine and dandy as far as it goes, unless you were an ExOne shareholder.  Who, by the way were the ones selling in the IPO.  One shareholder sold 300,000 shares in the IPO.  This means that this one shareholder transferred a gain of $2.4M to some connections of the underwriters.  This shareholder is taking $5.4M, less fees and discounts, call it $5M from of the IPO, so $2.4 is not exactly a rounding error.  Presumably, this shareholder is also more inclined to build companies with the capital than whatever speculators are hovering over the IPO.  Similarly, the company lost out on $40M of capital that could be invested in projects.  Think about that.  The company is worth less than $350M and the IPO mis-pricing cost it $40M of cash.  Cash!  Cash that could be sitting on the balance sheet scaring off competition and waiting for the next expansion opportunity.

It is hard to explain an IPO price that is so far below the fair market value of the company.  I know that there are a lot reasons why bankers try to justify under pricing an IPO, but giving-up over 10% of the firm’s market value in a single transaction seems really hard to justify no matter what.  I’m not sure what part of the economic gains from listing publicly should be given to financial intermediaries and incoming investors to get a deal done, but over 10% of the company seems quite excessive.  These new shareholders have no restrictions on ownership and quite likely to flip their shares instead of taking an active roll in growing the company, which seems to further erode any claim they might have to extraordinary gains.

I’m not familiar with the track records of FBR, BB&T, and Stephens, the underwriters for the ExOne IPO, but I’d think twice or three times about hiring them if I was going to do an IPO.  They seem to have not only underpriced the IPO, but also floated too much of the company, almost 40%.  Underpricing the IPO might be tolerable if the bankers had only floated 5-10% of the company.  The company could have done a secondary offering later once the offering had an established market price, instead of getting ripped off during the IPO.  The large offering certainly did do one good thing for the bankers: it increased the underwriting fee.

If my company ever goes public, I hope I’ll have the good sense to hire Morgan Stanley–unless an underwriter is involved in litigation for overpricing an IPO, how can you be sure they’re any good?  Heck, they even give discounts–what’s not to like!

The Knowledge Economy Cash Anomaly, Part 3: The exciting conclusion

This is part 3 in a series.  Here are Part 1 and Part 2.

Tax Shields 

The organization of the knowledge economy is inclined towards creating great tax advantages.  Both start-ups and mature companies enjoy huge advantages that the resource economy does not enjoy.  Most investments can be expensed.  The companies grow fast enough that they create huge tax losses, even as they create extraordinary value for the owners.  Once they become mature global companies, their assets can be transferred almost costlessly to whatever jurisdiction offers the most favorable treatment.  Transfer pricing makes it almost impossible for authorities to tell where value was added.  Money generated off-shore can stay off-shore tax free indefinitely.  In contrast, resource economy companies have easily traceable assets, some of which require particular locations and may be quite literally fixed to that location.  Their assets are comparatively easy to tax, whatever form their assets take.

If this is the case, it follows that knowledge economy companies have huge tax shields from their operations.  To have these tax shields add value to the business, the CFO of a company needs a business that is low risk, earns the cost of capital after tax, and does not consume much management attention.  Investing in marketable securities seems like just the ticket.  The gain on securities allows the owners of the company to take advantage of the tax shields that would otherwise go unused.

Here is what we’ve been looking for all along.  A reason why cash is better off in the pocket of the company than in the pocket of the owner.  In addition, all the other reasons why a firm might hold so much cash are still active and valid.  Full use of tax shields would be a driving factor for keeping cash on the balance sheet.  The discount rate for tax shields is low and even if only gets used every few years, it adds to the wealth of the shareholders.  For a founder, cash on the balance sheet capitalizes an otherwise unused tax shield, provides diversification, defends the core business, and enhances the value of R&D investments by its mere presence.

The question for further study would be when we would expect to see these benefits diminish?  Can we empirically test which of these hypotheses are most important in guiding payout policy?

The Knowledge Economy Cash Anomaly, Part 2

This is a continuation of Part 1.

Option Value of Cash on the Balance Sheet

This theory of the cash anomaly posits that the returns from R&D are high, but also highly uncertain.  Every once and awhile, the R&D of a company will produce a really high value project that requires massive investment and possibly acquisitions to use in combination with the asset.  The problem with R&D as an economic asset is that it is very difficult to sell or even be exploited by organizations other than the organization that developed it.  Unlike discovering oil, it is not clear even after discovery of a project that another firm could develop the project to create economic returns.

Because exploitation relies on unique capabilities inside the firm that are only poorly understood outside the firm, their economic value is harder to forecast.  This violates the costless symmetric  information condition of efficient markets is violated, unlike the projects of old economy companies, where the market has a reasonable expectation that it will understand the value of the project.  This uncertainty introduces huge frictions if projects need to raise new capital. Therefore, if a company has R&D projects, the value of that project stream is greatly enhanced if the company also has a means of financing the projects that does not require subjecting those projects to the friction of market financing.  These frictions are both directly financial in the form of more returns to new investors and intermediaries, and also temporal.  In winner takes all markets, which many technology markets are, temporal costs are huge.

The option value of cash on the balance sheet could be huge, however, we would expect more tech companies to at least on occasion, expend all their cash and perhaps even borrowing capacity when they exercised options if this were the case.  This is common in growing technology companies.  Mature tech companies, rarely, if ever come close to expending their investment capacity.

I’m skeptical of this explanation.  Why does Google need to hold enough cash to buy Yahoo or Facebook in cash, if they are never exercise the option to do so?  When was the last time you heard that a company was undertaking a project with more than a billion dollars of expenditures in year one of the project?  These kinds of companies can make acquisitions with stock, invest over time out of future cash flows, and they even have relatively low cost borrowing capacity should it be required.

Cash Poor at Home

Recently, much has been made of the U.S. companies that are parking cash overseas to avoid the tax when they repatriate it.  Many companies are cash poor in their U.S. entity, but their consolidated balance sheet shows a lot of cash.  This cash can’t be repatriated for distribution without a large tax bill.  This is the worst of all possible worlds from a policy perspective, but it doesn’t seem to afflict tech companies as much as industrial conglomerates.

(BTW, Congress doesn’t need to capitulate to corporate demands for no tax on foreign earnings.  All it has to do charge the companies income tax on their cost of capital for any overseas investments, then true up when the companies bring cash home.  Particularly if the law slightly over estimated the cost of capital, or ignored the cost of capital on financial assets in the WACC calculation, so that repatriating funds usually triggered a small refund rather than a small bill, you could just sit back and relax and watch them all bring their cash home while still paying tax.)

Distress Costs

The final explanation I’ve heard offered is the idea that since most of the investments of a technology company are in workforce and R&D, the costs of financial distress are huge.  Not only that, but the costs of financial distress can manifest themselves long before bankruptcy is close.  If managers are cutting benefits or tightening R&D activites, and the costs are not properly captured by accounting frameworks.  New talent goes elsewhere, the best old talent leaves, R&D becomes less creative, less real economic capital employed stealthily decreases without the accountants noticing.  However, CFOs are smart, they know this–even if the accountants don’t.  They keep cash on the balance sheet, employee benefits generous, and 10% time meaningful.  This prevents the stealthy erosion of the real assets of the company, by the prospect of distress, which the intelligent and savvy workforce is acutely aware of even if they don’t conduct formal analysis.

But there is one more reason…

In part 3, I will outline how holding cash creates economic value, regardless of and in addition to, all these explanations.  Go to Part 3.

Is anyone surprised the FAA is delaying UAS test site selection indefinitely?

I have to agree completely with the sentiments of Congressman Austria on this issue. The FAA is just dragging its feet.  The point of the test sites is to solve the issues of safety and privacy.  If these issues were completely worked out, we wouldn’t need test sites–do not pass go, do not collect more appropriations, proceed directly to airspace integration.

The point of the test sites is to work on these issues and give the general, civil, and commercial aviation community time to come to grips that some new craft are going to be joining their previously exclusive community.  Delaying the test site selection is the complete wrong approach.  The right approach is to begin testing–as most other developed countries already have.

How is privacy even the FAA’s jurisdiction?  In all seriousness, I hope that whatever regulations apply to UAS apply to cellphones.  I’m a lot more likely to have my privacy invaded through cell phone than through unmanned aircraft.

Is a dollar worth a dollar on a tech company’s balance sheet?

Previously, dear reader, you and I have discovered that robotics companies are firmly entrenched in the knowledge economy and their assets look like other knowledge economy companies’s assets.  Robotics companies only hold only a limited amount of real assets but lots of financial assets.

As a related question, what is the value of the cash (and financial assets) on the balance sheet to investors?  There might be several issues with holding so much cash.  Particularly, money in a company should be employed making more money, ‘earning or returning’ as the saying goes.   Are there valid reasons to hold so much cash?  And if so, how should we value the cash that knowledge economy companies hold?

Cash Is King! (Or at least a founding father)

Bottom line up-front:  Valuations are always wrong.  What’s interesting is how they are wrong.  Assuming a dollar is worth a dollar is as good a rule as any, but is almost always wrong.  Nobody is really sure which way (too much or too little) it is wrong.  Below, is an elaboration of some of the issues with valuing cash which may come into play when valuing particular companies.  (And you thought that at least cash of all things had a fixed value  —  don’t we all wish!)

There are various criticisms of excess cash on the balance sheet, below are some of the most common.

1)  Holding the extra cash reduces returns, i.e. to buy into the business you have to buy a pile of cash beyond what is ‘necessary’ to run the business.  Further, the rate of return on cash has been essentially zero and certainly below inflation lately, so holding the portfolio the stock represents of a highly profitable business, plus cash must necessarily produce a lower expected return than just the business.

2)  Because of agency problems, management may be incentivized to use the cash to reduce volatility or ‘save’ the business if it falls on hard times, even if the investors could get a markedly higher rate of return in the market.  From an investor’s point of view this would be systematically wasting money.  Employees, customers, management, and trading partners might have a very different view.

3)  Holding lots of cash is said to signal that the company does not have profitable investment opportunities commensurate with the cash that it is generating and the company’s growth may slow in the future.  Further, holding lots of cash signals that you don’t know, or are ignoring, the traditional Anglo-Saxon business administration.  English speaking investors generally expect management to maximize monetary returns over the forecasting horizon and put shareholder interests ahead of all others.

Some countervailing points that you will often hear are along the following lines. 

A)  Although holding cash reduces returns, for a volatile security like a fast growing knowledge economy company, having cash on the balance sheet dramatically reduces volatility.  If investors want more exposure to the underlying business for the same initial investment, lever-up.  Since we are talking about cash holdings, buying on margin is almost a perfect antidote to management’s lackadaisical cash management policies if you feel that way.  [But seriously, who is their right mind thinks you need to lever-up when buying tech stocks?]

B)  Although management might ‘burn’ cash saving a failing business, which would be better redistributed to investors, more likely, they are going to have the flexibility to engage in acquisitions and new ventures without having to deal with the whims of the security markets.  [Has anyone seen a rational market lately?  Please let me know.]

Or has anyone read the Wall Street Journal?  Tech companies are routinely attacked for having their fixed life fund investors exit—Groupon and Facebook each got front page hatchet jobs over the past two days with nary a mention that these funds had been planning to sell now for, oh say, 8-10 years!  Talk about journalistic malpractice.  Would you want to go to the public markets in that environment?  I sure wouldn’t.  If I was management, I’d say that if investors are that irrational, I’ll keep the cash and do what they should have done with the money.

C)  Finally, although cash on hand may sometimes signal that the companies are running out of investment opportunities, it certainly signals to would be competitors that the said company is in a position to stick around for a long time and bitterly contest any erosion of their market position.  This may greatly enhance the value of the underlying business asset.

D)  This is a successful tech company.  It is run by the founders, for the founders (i.e. management).  If you don’t want the privilege of investing and taking whatever returns the founders deign to give, please step aside and allow the next investor to purchase stock.  But this isn’t really a justification.  Founders are investors too, especially once the company goes public, with theoretically the same motivations as other investors since their stake is highly liquid.

Further research on technology companies and their cash management policies should address the following issues:

I)     Are there structural reasons beyond the creation of new businesses and defense of existing businesses for technology/knowledge companies to hold lots of cash?  It does not occur to me that there is anything about a maturing knowledge business that seems to require massive amounts of cash.  Law firms and accounting firms do not seem to hold too much cash, but they are also typically private and can make much more drastic changes than public companies.

II)   Are there frictions between the interests of various classes of investors?  Particularly when there is a founder controlled/managed company, cash on the balance sheet is probably as good to them from a control perspective as cash in the bank and better from a tax perspective.  Should investment banks or others creating the classes of stock have new mechanisms to deal with this?

III)  What are the true limits on investment opportunities?  My firsthand observation has been that the greatest constraint on growth of robotics companies is management attention.  It may be that most technology companies have massively profitable investment opportunities, but management attention is engaged on current projects and hiring into the management circle is not that easy.  What is the needed resource to change this?  How can cash be used to obtain this resource?  Can it?  Is passion required?

IV)  Are there ways that management could resolve some of the market frictions that require them to hold lots of cash?  The public markets seem to mercilessly abuse tech companies—no they don’t look like utilities, but the highs and lows that they are pushed to seems unjustified—there just doesn’t seem to be enough new information about their future prospects to justify either one.  Can management take steps to make access to public markets, particularly debt markets more reliable?  Could banks make money by providing massive, typically undrawn, lines of credit that would provide much of the same protections to management?

DARPA is about to show the Navy’s shipbuilding plan is bull****

What is a powerful enough word to describe how the Navy’s shipbuilding plan is wasting thousands of man years and hundreds of billions of dollars on prejudices, untested assumptions, and bureaucratic inertia?

Luckily, DARPA is doing exactly what Congress created them to do way back in the Sputnik era: they are creating and protecting against technological surprise.  It would be fantastic if the Navy would jump on board and run phase 7 of this recently awarded DARPA contract.

Source: DARPA

For those of you who do not come from defense, here is my take on the conflict between how the traditional Navy looks at ships and how DARPA and the embattled progressive minority in the Navy look at naval platforms including unmanned naval vessels.

The big, traditional Navy believes–and they have some experiences that gives rise to this belief–that naval ships ought to be flexible, broadly capable, and completely independent assets.  Take a modern Arliegh Burke class destroyer (DDG-51 class), the backbone of the U.S. fleet, as prime example.  It can deploy itself to the theater of operations, maneuver tactically, sense targets, make engagement decisions, engage the target, and retrograde tactically and strategically from the operation.  Moreover these ships can do almost every mission that they might be called on to do.  They are among the most capable ships at anti-air, surface, and anti-submarine warfare.  Additionally, they respond to things like pirates, search and rescue, and humanitarian relief operations.  Sounds pretty cool, right?  And it is.

However, being able to do everything comes with two main drawbacks.  First the ‘jack of all trades, master of none’ phenomenon is far more likely to be true because of design compromises in engineered systems than it is in people.  Second, adding all this capability costs a lot of money.  These destroyers are about $2B a copy and on the order of $1M/day to operate if you add in everything.  This means that we can only have so many and they cannot be everywhere.

DARPA and the progressive faction within the Navy believe that there is a fundamental change at hand in naval warfare.  Looking at how the Army/Air Force team conducts operations and the improvements in automation and communication technologies at sea, the progressives believe that the tradition of having big capital ships that do everything is outdated.

In contrast to the completely capable Navy platforms, Army units often only do one or two things.   Almost no Army units have strategic mobility.  Most can only do one or two things.  Intelligence units often only have the ability to sense. Artillery units only have the ability to do tactical maneuver and fire, but cannot sense.  Transport units move other units and equipment but cannot fire or sense; sometime they cannot even maneuver tactically.  The Army has huge staff units that do nothing but process information and make decisions to keep all these specialist pieces working in coordinated fashion on the battlefield.

DARPA and the naval progressives believe that a similar future is in store for the next globally dominant navy.  Which we hope will be, but does not have to be from the Unites States.  They envision swarms of inexpensive specialist vessels such as the one DARPA is building running around coordinated by a few manned ships.  The components of these fleets would be optimized to do a couple things well, be relatively–we’re talking about defense here–cheap, and be deployed in large numbers.

The reason that this is an urgent argument is that there is wide consensus within the U.S. Navy, across both the traditionalists and the progressives, that the Navy will not be able to meet its strategic obligations to our allies and American political leadership in a decade or two.  This is a ways off, but still within the service life of all the ships commissioned in the last decade.  The traditionalist seem to hope for a larger budget and the chance to ditch some missions (the Obama administration just took steps in this direction in their last budget), while the progressives say that if the Navy is receiving half of global naval spending it should be able to keep all its obligations by changing the way the Navy is organized.

The problem is that the traditionalists point out, correctly, that the progressives have not proved their scheme will work.  Then they say that they cannot cut even one ship or submarine which would build about a hundred of these future systems so that this alternate path can be tested.  It sounds to me like someone’s rice bowl is about to be overturned, and deep down they know it.

This is why DARPA’s ACTUV program is so important.  It puts at least one of these vessels out on the water so that people can see with their own eyes that they work.  They will be able to see the SAIC team turning around the vessel in record time and the ship controlled remotely and also sailing autonomously.  They will get to see that anti-submarine warfare works when done with a robot instead of hundreds of men on ships.  DARPA will start smashing the traditionalists reality, or at least put some big cracks in it.

Three cheers to DARPA for their continued work pushing the United States forward whether we all want to go or not!

Which VCs are investing in robotics? Here is the list.

the instrument of venture investment

source: SEC.gov

My overview of the Firms Behind the Hizook 2011 VC in Robotic List has graciously been published at Hizook.

Bottom line:  We don’t have a cadre of dedicated robotics investors, but we can get investment from the industries that serve as our customers.

I wish you all luck in getting some of that VC Cash.  …on second thought, no, actually, I don’t–I  wish you all luck in signing up major partners who will give you progress payments to complete your product without diluting your investment.

But whatever your situation I hope that you use the appropriate capital structure to make lots of robots, lots money, and lots of good in the world.