Sunday, April 6, 2008

Cash is King. Cash-Like is Not

I am writing this article in an effort to refocus the blame on who is really responsible for the recent write downs and charges that companies have been forced to take due to the drop in demand for auction rate securities.

There have been posts by many VC's recently on this issue including one by Fred Wilson Our Run In With Auction Rates And What It Taught Me About Markets where he explained what actions he personally took on his holdings in such debt-instruments to avoid such write downs or losses. He was prudent and also his investment advisors called him in a timely manner so that he could act on it. I am sure there were others who understood the potential risk of "cash-like" financial instruments and took timely action to mitigate the risks.

It is absolutely important to understand the complete risk and the liquidity situation of all your finances and investments. I am sure if the right questions had been asked and answered, and if the papers signed at the onset of the agreement stated that there are certain inherent risks associated with these arcane debt instruments, then the people who signed them bear the ultimate responsibility. One can't blame an institution for writing down the auction rate debt instrument and hence a loss on the value of the original cash investment, unless a fraud has been committed.

Late Last year after, after some of the initial shudders in some of the banks and brokerages, I re-evaluated all my accounts that I hold at various institutions, verified that they met the FDIC insurance limits (for MMAs) and that all the other accounts were under the SIPC limits as well. I called the various institutions, asked them to reconfirm the federal insurance amounts that they had taken on accounts, asken them what extra insurance they carried and how I was protected in case of a bank failure. Basically I did a complete "risk assessment". I did this to fully understand my "risk picture" - so that I knew what was "SAFE" and what was risky.

This is the same mentality that should be exhibited by a start-up company. The management along with the investors must assess and fully understand the risks associated with different kind of debt instruments. Past safe practices of such instruments does not necessarily mean continued safety. If someone made a suggestion to put in the company's cash originally acquired through Venture Funding, into auction rate securities, here are the questions that I would have asked.

1: how different is this from a money market account or a CD?
2: Are these deposits insured by the government if the bank failed or there was a "run on the bank"?
3: I understand that this has been done for the last X number of years, but can you tell me what are the possible scenarios under which this so called "cash-equivalent" can lose its value? Please give me the scenario however remote it may be. If you can't give me a scenario, then you the "bank" has to give me in writing that this is truly "cash" and is fully convertible to cash equivalent at a minimum of the original deposit.

The bottom line is, if the debt-instrument cannot be federally insured, then the accounts are not the same as "cash". Hopefully the investment professionals who advice on the portfolio construction for the cash that a company is sitting on, are astute regarding the risks associated with these debt-instruments. Its more important for you to ascertain if "cash-like-investments" is "cash".

You need to have an investment policy which you should review and question constantly. Ask those questions regarding risk freely without hesitation at the risk of appearing stupid. After all it the money with which you plan to build your company. You should always assume that no investment is risk free and the higher the apparent return the higher the risk.

Cash is King. Cash-Like is Not

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