Streetwatch
Victor Fleischer
Research Fellow in Transactional Studies, Columbia Law School[1]
January 2002[2]
Dan Jennings was eager to get started. His startup company, Streetwatch, rated Wall Street research analysts for institutional clients. Streetwatch had already gathered some momentum, but it needed more capital quickly to hire staff, de-bug the computer program (called “Watchman”) and take advantage of an employer-friendly job market. It was early January 2002, just over one year after Jennings had written up a business plan, gathered up seed capital and launched the company. The founders, each of whom put in capital, included Jennings himself, his former boss, Steve Newman, and two friends with experience in computer programming, Christine Raker and Bridget Cooley. They were now just about out of money.
Streetwatch aspired to answer the age-old question, “Who watches the watchmen?” – at least as far as Wall Street research analysts are concerned. Research analysts were being bad-mouthed in the press, yet again, for their biased judgment. Analysts have been criticized as little more than company cheerleaders (or worse, self-interested market manipulators) rather than helpful researchers. In the wake of the Enron collapse – where analysts almost uniformly maintained “Strong Buy” or “Buy” ratings on Enron stock until just before bankruptcy – politicians were wondering if analysts needed government oversight.
Jennings himself took a more balanced view of analysts and believed there was a private market solution to be had. Jennings had been a research analyst at a major New York investment bank until 2000, and he knew that a good research analyst could provide valuable information to his clients. An experienced analyst offered industry-specific knowledge, access to company insiders, thorough understanding of company earnings and how that translates into stock price, and knowledge about how a company should perform relative to its peers, and why. Even if an investor came to make her own judgment about whether to buy or sell a stock, the work of a good analyst was a valuable resource. By ranking analysts for institutional investors, Streetwatch could help match up investors with good analysts.
Jennings also knew the limitations of the job, and he believed Streetwatch could help in that regard as well. Analysts labored under an intense conflict of interest. The investment banks, which employ the “sell-side” analysts, directly and indirectly pressure their analysts to shade their forecasts positively – so as to curry favor with the company they cover and reap lucrative investment banking fees. A negative or neutral forecast or rating, if viewed as unwarranted, could negatively affect an analyst’s bonus, which usually comprised half or more of her annual compensation. The real money came in from underwriting fees, and firms rarely let the analysts forget this. Even apart from this pressure, analysts have a natural tendency to move as a group and avoid risky predictions (especially negative ones), even if their own research suggests that bad news is to come. Moreover, a negative forecast could sour relations with the management of the companies an analyst covered, making it even more difficult to obtain good information. By penalizing analysts with bad rankings when they remain overly optimistic and rewarding analysts who hit the mark, Streetwatch would help pressure analysts to remain more objective.
Jennings and his partners had spoken to many of their former clients (mostly institutional investors) and several dozen had signed up for Streetwatch’s services. Jennings was still designing the pricing structure (the clients were paying a nominal fee at the moment), and he wanted to make sure the technology ran smoothly before launching. Streetwatch’s current clients were helping “beta-test” the computer program, and it looked like the technology would launch smoothly. Jennings thought it would take about a year before they really knew how well the product worked: year-end earnings for most companies come out in early or mid-February, and Jennings expected a surge in interest and Internet traffic just before and after that time period.
Jennings knew that if Streetwatch developed a good name it could become an integral part of the Wall Street research world. In theory, the marketplace for sell-side analysts would police itself. Bad analysts would develop bad reputations, and investors would seek out the advice of (and bring their business to) investment banks that employed the best unbiased analysts. But, in fact, the market was having trouble policing itself. Among other things, the number of analysts continued to increase, and it was increasingly hard for investors to keep track of who had real expertise in what area. Moreover, investors relied heavily on word-of-mouth reputation, which could sometimes be useful, but also proved unreliable and difficult to interpret. Put another way, the market for analyst reputation was failing because there was no central clearinghouse for information.
Streetwatch aspired to satisfy the need for more reliable information about research analysts. Jennings knew that investors and buy-side analysts would continue to rely on the sell-side analysts working for the investment banks, if nothing else to find necessary cover and support for their own recommendations. Streetwatch would make the research analyst landscape a bit more defined and objective. Analysts filled a useful niche as informational intermediaries, but it was becoming exceedingly difficult to tell who was in the know and who was just pretending; who was basing their opinion on thorough research versus who was just parroting the company’s own forecast. By deriving revenue from the investors rather than the companies, Jennings hoped that Streetwatch would soon develop a reputation for integrity and trustworthiness, becoming the “Consumer Reports” for Wall Street.
Kiplinger’s offer to invest. As his friends were gathering in his apartment to watch the Super Bowl pre-game show, Jennings sat in his bedroom looking over two stacks of documents. The first proposal described a proposed investment in Streetwatch by Kiplinger.com, a division of the privately-held Kiplinger Washington Editors Inc. Kiplinger is best known for its flagship product, Kiplinger’s Personal Finance magazine, a monthly publication with a circulation of about 3,000,000. The Kiplinger term sheet (Exhibit A below) called for Kiplinger to buy 2,000,000 newly issued shares of common stock from Streetwatch, which would eventually result in Kiplinger owning just over 50% of the company. The proposed purchase price was $2.00 per share. The resulting $4,000,000 infusion of capital would take place in three stages over a two-year period as called for by the Streetwatch business plan. All three stages of the investment would be mandatory, however, regardless of whether Streetwatch meets the goals of the business plan. The staging was designed so that Kiplinger would not have to invest cash before it was needed by the Streetwatch business.
Kiplinger promised to help Jennings move the business forward, but it appeared that it could, in fact, offer little more than technical support. Kiplinger’s staff included many journalists and editors familiar with Wall Street, but nearly all of them focused on personal finance rather than institutional investing. Once the Streetwatch website was launched, Kiplinger planned to ask Jennings to dismiss the tech-savvy founders Raker and Cooley to put in Kiplinger’s own tech people to maintain the site, but would allow Raker and Cooley to retain their common stock and consult with the Company as needed. Kiplinger viewed Jennings and Newman as the key to the Company’s success. Jennings would remain CEO of Streetwatch, and Newman would remain Executive Vice President in charge of client relations. Jennings and Newman would each receive five-year employment contracts with a good salary and significant stock options. At any point during the next ten years, Kiplinger would have the option of buying Jennings’ and Newman’s existing common shares at a strike price of $8 per share. The Kiplinger option, however, did not extend to any options which Jennings or Newman exercised. Kiplinger also agreed to give Jennings and Newman a put option on their existing common shares which would vest in two years, payable in cash or Kiplinger stock (at Kiplinger’s option) at a price of $1 per share.
Tom Wheeler’s offer. Tom Wheeler was an old friend of Jennings’ partner, Steve Newman. Wheeler had a networking list on his Palm Pilot that was as deep as anyone’s on Wall Street. Wheeler had left his job as a top research analyst some years before and now provided consulting services to various institutional clients. Wheeler was intrigued by Streetwatch, and he proposed the following investment in the company (Exhibit B below). A group of private investors, headed by Wheeler, would invest $1,750,000 in Streetwatch. Wheeler’s group would receive participating preferred stock, convertible into common stock at Wheeler’s discretion.
The Preferred would receive an 8% cumulative dividend and would have a “2x liquidation preference” over the common. This preference means that in the event of a liquidation or sale, the preferred shareholders would make back twice the amount of money they invested, plus dividends, before the common shareholders received anything. In addition, the Preferred would “participate” with the common by sharing pro rata with any remaining assets after it had received the liquidation preference. The Preferred would automatically convert to common and the liquidation preference would disappear upon the closing of a qualified IPO.
Wheeler would also receive an option to acquire another 500,000 shares of Streetwatch at the same price, exercisable one year from the closing date. Because Jennings believed that the company would increase in value, he was reluctant to promise to sell new shares to Wheeler at the same price of $3.50 per share. Wheeler would pay Streetwatch $250,000 for the option, bringing the total amount of cash coming in to Streetwatch to $2,000,000. If Wheeler exercised the option, he would then control about one-third of the outstanding shares of the company.
Jennings knew that he would have to give up some control of the company in order to raise capital, but he was sad to see how much things had changed since the hey-day of the Internet frenzy. Kiplinger viewed itself as a big, friendly, resource-rich partner, and Jennings’ negotiations with Kiplinger were easy – except for the price. The Kiplinger offer took away a great deal of Jennings’ upside potential in the venture. The Kiplinger valuation of the Company was low. And while Kiplinger left Jennings with day-to-day operational control as CEO, Kiplinger would within two years have enough common shares to take control of the enterprise. On the other hand, it seemed unlikely that Kiplinger could acquire either the contacts or expertise to run Streetwatch effectively, so Jennings at least felt that his job would be safe.
The Wheeler group offer gave Streetwatch a higher valuation, but arguably extracted more power over the company’s future. Wheeler would have three seats out of seven on the Board from day one, which means that he would want a voice in the long-term strategy of the company. Moreover, Wheeler seemed distrustful of Jennings’ ability to lead the company and did not offer him an employment contract. Jennings was not even sure what Wheeler’s plans were.
Significantly, Jennings was concerned that the $2,000,000 put up by Wheeler would not carry the company long enough to turn a profit, and Streetwatch would have to raise more money from the Wheeler group or another source in about a year. The term sheet also gave Wheeler the right of first refusal over any new issuances of Streetwatch stock. In contrast, the $4,000,000 offer from Kiplinger would probably carry Streetwatch all the way to profitability, and, indeed, even gave Streetwatch a bit of a cushion in case costs exceeded the initial projections. (See Exhibit E below.) On the other hand, the Wheeler group offer did allow Jennings and Newman the possibility of participating in the upside potential, which Jennings was confident of. If things worked out, Jennings thought the company could have revenues above $20,000,000 per year and, he believed, had the potential for a very successful IPO.
Jennings tucked the documents into his briefcase and went back to the living room to join his guests and watch the game. He would have to make up his mind before meeting with Newman, Raker and Cooley the next day, as both Wheeler and Kiplinger were expecting answers by the end of the week.
Background
Sell-side research analysts have a tough job. They are typically responsible for at least a handful of companies in a single industry or related industries, such as telecommunications, airlines, banking, or tobacco. Through independent research, private phone calls and meetings, conference calls with company management, and general market awareness, analysts write up reports or “notes” on the companies they cover, as well as make earnings projections and buy, hold or sell recommendations. They must constantly keep abreast of each company’s press releases, earnings and revenue projections, and so on, all the while keeping an eye on broader trends in the industry and market as a whole. Analysts tend to move in a herd, since it is generally thought to be safer to be wrong if one is surrounded by good company.
Earnings forecasts are at the core of an analyst’s job. Companies release earnings projections, typically on a quarterly basis but sometimes updated more frequently. Companies make their projections based on their internal financial information and management projections of how the company will fare in the upcoming weeks, months and years. Analysts take these company projections and make their own forecasts, reflecting their own research, discussions with management, and more detailed examination of the industry and company financials. A company named “Thomson Financial / First Call” compiles the forecasts of all the various industry analysts to come up with a “consensus” forecast. Companies, in turn, are under tremendous pressure to meet or beat the Street estimate, and stock prices often move significantly in response, especially when a company misses “the number.”[3]
So, for example, in 2001 Amazon.com had predicted a small loss in the fourth quarter of 2001, then adjusted their earnings projection downwards on several occasions to reflect a slow holiday shopping season. The consensus estimate was for a loss of 7 cents per share for the quarter. In mid-January, Amazon surprised the Street by reporting a 9 cents per share profit for the quarter. The unexpected profit was the result of a combination of (1) better-than-expected book sales and (2) a decline in the Euro, which allowed Amazon to pay less on its Euro-denominated debt. Analysts who were able to forecast either the better-than-expected book sales or figure out how the decline in the Euro would affect Amazon’s earnings provided more accurate earnings estimates and more useful explanations of Amazon’s reports.
Really good analysts are hard to find. Obviously, an analyst who can reliably forecast when a company will “beat the number” or “miss the number” is worth a lot to an investor. Even if an analyst is wrong much of the time, anything better than 50-50 tends to improve her client’s position vis-à-vis the market as a whole. But few analysts are willing to risk being the first to sound negative news. As part of the job of a good analyst is to form a relationship with company management, analysts sometimes have trouble turning around and bad-mouthing the same people who have become their friends. Moreover, negative comments make it less likely that a company will bring investment banking work to the firm that made the negative comments, and an analyst’s compensation is directly or indirectly tied to the amount of investment banking fees brought in to the firm.
The Streetwatch Strategy
Jennings had a two-part strategy for Streetwatch. The first was to provide investors with an objective approach to rating the analysts. Raker and Cooley had written a computer program (Watchman) that gathered information about analysts’ earnings estimates, upgrades, and downgrades and then matched how each analyst fared as compared to the Street average. This part of the Streetwatch rating would be entirely based on publicly available information and would be transparent and verifiable, ensuring objectivity. Thus, on a continuous basis, the computer program would review how each analyst in each industry had performed and give them a grade from A+ to F. The grades would be skewed to place more importance on recent forecasts, but would reward past experience to some degree.
The computer program still had some bugs and would need constant attention to ensure that the information it gathered was accurate and up-to-date. But the beta-testing was running fairly smoothly and Jennings and his colleagues had been working steadily to expand the number of analysts the program covered. Kiplinger had expressed concern that the website would need much more support as the number of clients grew, and they felt that their IT people could improve the situation. The real test would come in January 2003 when analysts predicted year-end earnings and traffic to the site increased.