Berkonomics – Business Insights from Dave Berkus

          Once a company founder has tapped the funds available from his or her resources and from friends and family, if the company needs more cash for growth, the most obvious next step is to look for money from angel investors and venture capitalists, typically in the $300,000 TO $3,000,000 range.  This money comes with restrictions a founder may not expect, including restrictions upon the sale of founder stock, clauses that require the investor be allowed to sell an equal proportion of stock upon any other person’s sale of stock, anti-dilution provisions that protect the investor from a subsequent offer of stock at a lower price, and much more. 

          Almost always, professional investors, including angel groups and venture capitalists, also require at least one seat on the corporate board.  The investor organization is granted the seat as long as the investment remains, and the documents often name the first representative assigned by the investor group to the position.

[Email readers continue here...] In subsequent insights, we will explore the legal and ethical responsibilities of board members.  But the intent of these “forced” placements of a representative on the board is obviously to watch over the company’s use of invested funds and to help grow the company in value.  The combination of restrictive covenants in the investor documents and the new dynamic of board members with an agenda make for a change in the culture of the corporation, certainly one for the CEO.

           However, outside professional investor board members can be a very good asset to the corporation with the skills, experience and broad relationships many bring to the boardroom table.

This statement could be considered controversial.  We have previously made the case that professional investors demand more in the form of restrictive covenants and lower valuations.  Now we explore the other side of that coin.  Professional investors usually bring “smart money” to the table, defined as money that comes along with good advice and great relationships for corporate growth.  Often, that money is worth more than the cash invested, because the investors who often become members of the board, bring a wealth of experience, insight, relationships and deeper pockets to the table. 

                I serve on the boards of several companies with just such VC talent at the table, partners in firms that made subsequent investments in companies where I either made early investments or led a group of fellow investors in early rounds of finance.  Each of these companies needed more cash than professional angel investors were willing or able to provide, and we turned to the venture community for larger investments. 

[Email readers continue here...] Attracting a VC investment means finding a partner in a VC firm who is willing to champion your opportunity before his partnership and then represent his firm with a seat on the board once the investment is made.  In a number of cases, these VC partners have made the difference between success and failure or at least growth vs. stagnation.  These VC partners have relationships with later stage investors further up the food chain, with service providers, with potential “C” level senior managers, and with other CEO’s with great timely advice or partnering opportunities.  In one such recent case, the angels were tapped out at $6 million invested, an amount far above their usual taste, but for a company with a billion dollar potential.  The VC’s that subsequently invested $18 million to date are looking for the billion dollar valuation someday, well beyond what angel investors usually are able to project from their own resources.  Whether this business and entrepreneur make it to the rare billion dollar club or not, without the VC guidance there would have been little opportunity to even dream of such a goal.  There is no question that the company took smart money and leveraged it for maximum growth, using the money, guidance, contacts and more from these large VC investors.

                So now we have explored the early stages of formation and finance.  It is time in the next posts to fine-tune the business and its strategic plan to exploit its maximum potential, finding the ideal niche for a company and its core competency…

This insight follows closely the conclusions from the previous declaration, that professional investors negotiate tough terms, from provisions of control over asset acquisition, eventual sale of the company, future investments, forced co-sale when others attempt to sell their shares and more.  And yet, in an earlier insight, we spoke of the problems that come when taking unstructured investments from friends and family.  So how does the statement above fit into this sandwich of alternatives?

                Trusted, close resources include sophisticated relatives, friends and business associates who know how to structure a deal as a win-win for you and for them, while allowing you to retain control over your vision and execution.  Their investment should be structured with the help of a good attorney who understands the mutual goal of maximum leverage of funds with minimum interference in your business decisions. 

                Remember the admonition that investment from such close sources carries an additional burden for you – to protect your investors and their investment as if they were your alter egos, offering money as if from your own pocket.  Such money should never be taken without clear understanding of the terms, whether a loan with a reasonable interest rate and strict repayment terms, or an investment valuing the company at an amount considered reasonable by a third party professional, even if as a sanity check as opposed to an appraisal.  This money is personal, an investment in you as much or more than in your company.  The degree of care you take increases with the reduced distance between you and your investor. 

                [Email readers continue here...] My very first investment as a professional angel was in a small startup where the entrepreneur’s vision fueled my imagination in the audio market niche where I had run a business in an earlier life.  I was so enthusiastic that I coached the entrepreneur to approach his mother, who invested $50,000 under the same terms as my investment.   A small venture firm and a few more angels rounded out the total investment.  As the company grew and became profitable, it became more visible to others in the market niche.  Two of us who invested served on the board of the company, advising the first-time entrepreneur with our business and industry experience.  Several years later, with the approval of the board and entrepreneur, I was able to engage a very well-known potential acquirer of the business who offered an attractive price for the still-young but successful enterprise.  After weeks of negotiation, the entrepreneur suddenly disengaged, claiming that he was no longer interested in a sale of his company.  The rest of us were shocked and disappointed that after weeks of work and a fair price, we were left with nothing but to follow his lead and disengage.  Shortly thereafter, in a board meeting, I brought up the issue of starting to pay board members for service in cash or in stock options, typical for outside board members but rarely for investors.  The entrepreneur was angry, abusive, in his negative reaction to even bringing the issue to the board for a discussion.  Five years had passed from my original investment in what I now clearly perceived as investment into a lifestyle business, one where the entrepreneur had no interest in selling or sharing.  I resigned from the board on the spot and negotiated a sale of my stock to the entrepreneur at five times the earlier investment, a fair return for both, since the company was by then worth much more.  It is now years later, and his mother along with other early investors are still in the passive game, not likely to see liquidity from this mistaken investment in an entrepreneur unwilling to take money in exchange for the eventual promise of liquidity.

                Why tell this story at all?  Mother is surely satisfied as a passive investor who probably would have given her son the money without structure.  The other investors are probably in the unhappy never land of not being able to see liquidity after a decade and unable to write off the investment as a loss for tax purposes.   This story would probably have ended in a lawsuit if a larger professional investor had been involved, since the entrepreneur did not follow the rules and seems to have no desire to do so.

                Trust works both ways.  Take money from close resources, but treat it as if the responsibility is even greater to protect the investors and their money than from a professional.   These investors trust that you will do the right thing for them if at all able.

Taking in angel or venture money requires a setting of an entrepreneur’s expectations that may come as a shock at least at first.  From the moment such an investor looks seriously at your company, the investor or VC partner is thinking of the end game, the ultimate sale of the company or even of an eventual initial public offering.  There is no middle ground.  Taking money from these sources involves resetting priorities over time.  There is no such thing as a lifestyle business with outside investors. To protect against such an event, almost every professional investor includes a clause in the investment documents which allow the investor to “put” the stock back to the company after five years, requiring the company to pay back the investment plus dividends accrued during the term of the investment.  This sword hanging over the company is not often used, but is a constant reminder that an outside investor is serious about getting out, hopefully in less than five years, at a profit, usually from the sale of the company.  Many companies find themselves at the five year point completely unprepared for a sale and without the cash resources to carry out such a repurchase of investor stock, making the clause moot.

[Email readers continue here...]  There are also clauses in many such investor documents that allow the investor to override the founder and force a sale of the company if a proposed sale is attractive to an investor for liquidity, even if the founder feels that there is much more potential if the business is not sold at the present time.

Finally, it is an unfortunate fact that when a company needs money and has not met its original planned targets, the newest investor prices the round at a level below the last or last several rounds of financing, angering and frustrating previous investors who took what they perceive as the greatest risks by investing before the business proved itself.  The last money has the first say – in valuation and in sometimes forcing draconian terms that require prior investors to contribute a proportional new investment to retain a semblance of their original rights and avoid dilution or worse yet, involuntary conversion to a lower class of stock.  As the years progress with typical VC firms seeing lower returns than expected by their limited partner investors, such terms are more common in secondary rounds of financing, causing a real riff between angel investors and their former close allies, the VCs, with whom they had once coexisted as suppliers of deals at expectedly higher valuations at each state of investment.

So be aware that professional investors are in your company for the eventual large profits at the liquidity event.  They are your friends only as long as you meet or exceed planned growth and value.  They tolerate you and your management when the numbers are a bit murky but with an explanation that is believable and correctable.  They act in their own best interests when things go south. That’s just the facts.

This post will be perhaps a bit longer than usual, but certainly of great interest for those with interest in or have need for more capital…

This stage is critical to many businesses and a passing option to others, depending upon the capital efficiency of the enterprise.  Some businesses require very little capital and the founder is able to self-finance the enterprise and retain 100% of its ownership and control from ignition through liquidity event (startup through sale).  For you who fit that description, nice work.  For the rest of us desiring to build large, valuable enterprises quickly, the need for outside capital is high on our list of requirements and even the source for some sleepless nights as we worry over the availability and cost of capital.  It is for this group that we explore the implications implicit in raising money for growth.            

Before we explore the next insight, it might be useful to list some of the ways in which you can raise money for growth with and without outside investors. [Email readers continue here...]

                Bootstrapping:  This term describes your ability to start a business with little investment and grow it using internally-generated funds.  Certainly bootstrapping is a preferred method of funding growth if it does not hold back the speed of growth or hobble the quality of product or service to the extent that better-funded competitors can overtake the business.  There is a lot to say about retaining control.  You will realize much more from the ultimate sale of your business even if at a considerably lower price than if splitting the proceeds with investors.  You will have more control over strategy and execution than with an outside board overseeing planning and performance.  But few businesses grow into the sweet spot of $20 million to $30 million in worth to an ultimate buyer without the injection of outside capital.

                Friends, family and fools:  This term, although pejorative, describes the typical mix of early investors in a small, young growing business.  Money from these sources is relatively easy to come by, and most often comes with no strings as to oversight by a formal board composed of these investors and management.  However, most often, these funds are solicited by a well-meaning entrepreneur from investors who are not qualified as accredited investors under the law (currently requiring a proved income of $200,000 a year or $1 million in net worth for an individual investor).  I’ve arrived at a significant number of companies that were looking for additional growth capital after a “friends and family” round, and had to “clean up” the cap table more than a few times over the years.  Taking this kind of money has a number of pitfalls you should be aware of.  It is most common to greatly overprice such a round of financing, valuing the enterprise well above what it may be worth at the moment for friend or related investors who do not have the sophistication or willingness to challenge the valuation.  When professional investors look at such overvalued prior investments, they may refuse to become involved with a company, knowing that there will be, at the very least, universal disappointment and anger from prior investors when a new round is priced lower than the earlier friends and family round.   Sometimes this money is just too available and the risks seem so far away; so an entrepreneur will take the money and put off the worry over the eventual consequences, all in the hope that no more investment will ever be needed and everyone will be richer for the effort.

                Using your bank credit line and credit cards:  Even with the credit crunch signaled by the recent recession, many banks will issue business credit cards with a $50,000 limit if the entrepreneur is willing to personally guarantee the balance, and has the net worth to do so.   And even with the significant cost of credit card debt, many entrepreneurs aggressively use existing cards to finance a startup.  It’s an option, even though an expensive one.

                “Strategic partner” investors: If you can find a strategic partner willing to invest in your enterprise, consider it a blessing. Whether the partner is a supplier looking to gain a lock on your business as it grows or a customer looking to create a competitive barrier through use of your product, such an investment typically carries fewer restrictions than from a professional investor and less oversight.  Better yet, the valuation of your enterprise is often higher than if the same investment were taken from a professional investor.  Strategic investors validate a business, by their presence creating the very value they pay for with increased price per share purchased.  It is most often a win-win for both you and the strategic partner.

                Professional angels:  This is the arena where I work and play.  This class of investor, once quite disorganized, has become much like the venture capital community, creating a process including due diligence (careful examination of a business before investment), terms of investment that match those of venture capitalists, and a process that often takes months from introduction to investment.  Yet, professional angels are usually willing to take active board seats in a young enterprise and act as cost-free consultants to the CEO-entrepreneur, giving freely of their individual and collective years of experience, often in the same industry as the investment target.  Do not expect grand valuations of your enterprise from these professional angels. They have been burned too badly during the last decade by overvaluing businesses and finding themselves like friends and family, “stuffed” into a down round of lower valuation when a company takes its next round of financing from the next step, venture capitalists.  Professional angels, often organized into groups, usually invest from $100,000 to $1 million in a young enterprise.

                Venture, private equity and more:  Here we lump a large number investor classes into one.  Venture capital comes with a cost, and there are no bargains for the company when taking such an investment.  VC’s value an enterprise lower than others might at the same stage of investment, always aware of the need to create opportunities for “home run” profits at exit, since over fifty percent of their investments typically are lost when companies die before an opportunity to sell to others.  Further, as a class, VC’s have not done well for their own investors over the past decade since the bubble burst, making it doubly important to fight for low valuations and high profits at exit.  VC’s do not even engage in discussion with most of those entrepreneurs seeking capital. By some estimates, 95% of contacts are ignored unless they come as referrals from trusted sources such as known lawyers, accountants or fellow VC’s.  And just for measure, VC’s fund less than 2% of all deals they do investigate.  Typical VC investments begin at $2 million and quickly rise to $5 million and above, depending upon the size of the fund and stage of investment.  Terms are much more restrictive than from strategic or angel investors, often requiring the entrepreneur to escrow his or her founder stock for a number of years to prevent the founder leaving, and restricting the sale of prior stock without the VC also being allowed to offer a share of its holdings in the same sale. 

                Private equity investments are available from firms created for this later stage opportunity, but typically are available only for businesses that have achieved revenues well above $50 million.  Often private equity investors will want control of the business as well.

                Bank lines of credit are often available to businesses that are profitable, most often personally guaranteed by the entrepreneur, but available at a cost in interest less than most any other source.  Small Business Association (SBA) federally-guaranteed bank loans are becoming available again after years of limited activity.  With some restrictive provisions, these loans are favored by many banks as carrying much less risk than loans without the guarantee.

                But it is the outside investor that validates a business, often influencing growth with shared relationships, experienced guidance and providing a gateway to needed resources.  There are a few insights that relate to this money resource, and you should know and respect these.  We will cover these insights in the next several posts. So stay tuned…   

             For those of us who’ve invested in early stage companies, especially technology start-ups, we have confronted a universal problem.  There are many ways to project the value of a company for purposes of pricing an investment, but all rely upon the revenue and profit projections of the entrepreneur as a starting point.  Many formulas then discount those projections according to some set percentage or by assigning weight to elements of the enterprise.

             And in my opinion, all fail to take into account the universal truth – that fewer than one in a thousand start-ups meet or exceed their projected revenues in the periods planned.

            Years ago, confronted with the same conundrum, in the middle 1990’s I came up with a method of assessing the value of critical elements of a start-up without having to analyze the projected financials, except to the extent that the investor believes in the potential of a company to reach over $20 million in revenues by the fifth year of business.

            First published widely in the book, “Winning Angels” by Harvard’s Amis and Stevenson with my permission in 2001, the method has undergone a number of refinements over the years, particularly in the maximum assigned to each element of enterprise value, reducing those amounts as the investment market adjusted from the craziness of the bubble to more logical values in the years that followed.  Because the Internet has such a long memory and documents from the distant past can be found with ease, a search the “The Berkus Method” today will yield a number of conflicting valuations culled from the many subsequent publications of the method over the ensuing years.

[Email readers continue here...]  Here is the latest fine-tuning of the method. You should be able to adopt it to most any kind of business enterprise if your aim is to establish an early, most often pre-revenue valuation to a start-up that has potential of reaching over $20 million in revenues within five years:

                Note that these numbers are maximums that can be “earned” to form a valuation, allowing for a pre-revenue valuation of up to $2 million (or a post rollout value of up to $2.5 million), but certainly also allowing the investor to put much lower values into each test, resulting in valuations well below that amount.

                There is no question that start-up valuations must be kept at a low enough amount to allow for the extreme risk taken by the investor and to provide some opportunity for the investment to achieve a ten times increase in value over its life.

                Once a company is in revenues for any period of time, this method is no longer applicable, as most everyone will use actual revenues to project value over time.