BERKONOMICS – Business insights from Dave Berkus

You’ve heard the old one – that a banker always seems willing to offer a loan when you don’t need it.  For small businesses, there is such truth in that statement that you can trust the story to be based in reality from experience.

There are great exceptions for growing businesses and for businesses that have a track record with a banker.  Working capital loans and lines of credit are needed for growth and during times of business stress.  If a business were operating above breakeven and revenues and expenses steady, profits would flow to either the shareholders’ pockets or to working capital and taxes. Each cycle gives the CEO a chance to use those profits to some positive advantage, including increasing the marketing budget, paying down loans, building working capital, increasing “sticky cash” balances or paying shareholders.

[Email readers, continue here...]  But if a good business finds itself in a bad downturn, there may be a need that did not exist before for temporary cash, even as management reacts and moves to trim fixed overhead.

Approaching a banker during such times tests relationships.  If there was no previous relationship, few bankers would rely upon anything but a personal guarantee backed by hard assets before considering a loan.  But for those wise executives who included their bankers in occasional update calls, press releases, invitations to company events and an occasional personal visit, the strength of the relationship will often show its benefits during times when lending rules of the bank are near the “can’t do it” point.

For those with existing bank loans, that constant attention is more than just important.  As loan covenants become closer to being violated or after such an event, bankers have some latitude in deciding how to handle their accounts.  Upon discovery without prior notice or updates, bankers sometimes turn the company over to the bank’s workout group – a place you never want to visit.  In the gray area where covenants are broken but barely, covenants can be waived for a period of time as companies rectify the problems, all based upon the quality of the relationship between banker and client.

It is during those challenging times that it is most difficult to tell the story to your banker, but just then the most important of times.

Investors sometimes join into investment rounds that have been pre-negotiated by others, receiving the paperwork already created by attorneys from that negotiation.  It is not uncommon for a sharp investor to discover a “stinky” clause or two in such agreements when reading them in preparation for signing.  Bill Payne came across just such a stinky clause in a recent deal we both were late in the process of joining.

Changing the deal that late in the game is nearly impossible, after other investors have already completed their documents and the deal supposedly put to bed.  So what does the latest tag-along investor do?

You can tell from the title of this insight that the usual result is to passively sign while holding the nose, a trick perfected by experienced investors suffering this malady for not the first time.

What if it is the company attorney or entrepreneur that finds the stinky clause so very late in the game?  How do you confront the investors who have already agreed to terms and even perhaps signed their documents?  Is it worth risking the deal to negotiate a late change during the equivalent of the ninth inning?

[Email readers, continue here...] The answer is obviously in the importance of the issue to the person discovering it.  In most cases, the probability of whatever the clause being triggered sometime in the future is slight, and therefore the risk remote.  So it is a bet against the event made with chance on your side.

Then again, it is those improbable future events that end up causing lawsuits years later, often just because a party to an agreement did not understand the implication of a clause or even a document.  We hire attorneys precisely to help us prevent future conflict by resolving issues before they happen.

Most of us will let the matter slip and sign while holding our nose, a feat in itself (holding the nose, paper and pen at the same time).  Some of us will pass on the deal rather than confront the issue, especially if it is an important one to the late signer.  And that often happens when just such an issue has bitten the candidate investor in some past deal, making the likelihood of such negative reaction higher with sophisticated, long time investors.

Maybe there are skunks in the woods that don’t even know they smell.  Or maybe there are targets in the woods without the capacity to even catch the odor of a bad negotiation or deal documentation.  Either way, there are risks in deals we sometimes never catch – that later catch up to us in the most surprising places and times.

This important variation on “money talks” is an important consideration for entrepreneurs when seeking an investment from professionals such as VC’s.   Something like a marriage (and often lasting just as long statistically), your investment partner can be a great cheerleader, coach and resource.  But the moment things turn sour, including missed plans, some investors on company boards go into a predictable mode of dictating terms for emergency loans or additional investment.

These include forcing early investors to “pay to play,” or invest their pre-rata amounts to keep their original percentages, or suffer the consequences of being diluted to the extreme and losing preferences in a liquidation.

The reaction to bad news by VC’s controlling the board by virtue of their power to supply additional money, often includes the threat – or reality – of starting the process to find a replacement CEO.  So the combination of bad news and VC or professional investors on the Board can be volatile for the founders or management.  Angel investors tend to be much more understanding, and usually resort to coaching rather than replacing the CEO during bad times.

[Email readers, continue here...]  These are only a few of the considerations that have caused an increasing number of early stage entrepreneurs to draw business plans for companies that can be grown with angel and friends-family capital.  It avoids the increased risks and pressure that come with subsequent VC investments.

On the other hand, if a business needs large amounts of capital in order to succeed, the entrepreneur and board should contemplate the advantages gained against the increased risks, making a conscious decision to go for the growth with such funds or to grow organically – or to grow with a smaller round from internal investors.

There is a natural fear of giving too much information to investors after the initial investment is received.  CEO’s worry that investors will not keep the information confidential and that financial data will find its way into competitors’ hands.  Others worry that investors will latch onto individual line items within financial data and engage in inquisitions regarding telephone bills, marketing costs and other tactical line items in detailed financial statements.

First, let’s cover the absolute minimum legal requirement a company has to provide to its investors.  There must be an annual meeting of the shareholders, and that meeting must be announced with a written notice at least twenty days prior to the meeting. (There is a provision that a waiver of notice may be signed preventing this need, but it requires that all shareholders sign).

[Email readers, continue here...] At the annual meeting (which can be attended by phone), there are actions that require a vote of the shares present either by proxy or in person. These include election or re-election of board members if required by the bylaws of the corporation, approval of any increases to stock option plans (which would dilute the worth of shares outstanding), and approve any additions to the capital stock authorized to be issued.  Shareholders may vote on other issues during the year by written consent, including acquisitions, stock issuances, changes to the articles of incorporation and bylaws, and more.

But the question that is most often asked is: “How much financial information must be divulged?”  The answer is that the minimum requirement is to provide an income statement and balance sheet to all shareholders annually.  There is no requirement that either be detailed by general ledger account, and those statements should rarely be that detailed anyway.  Summarizing income statements with a line for revenues, cost of revenue, general and administrative expenses, sales and other direct costs – all leading to net income, would satisfy the legal requirement for statement of income and expense.

When a company accepts an investment from professional or organized investment groups – such as angel groups, venture capitalists or corporations, there is usually a document signed called an “investors rights agreement” that calls out additional financial and narrative reporting requirements due to that class of shareholder.  These could include the need for audited financials, monthly financial and narrative reporting and more.  That burden is an ongoing cost of taking the investment, much as a public company takes on the additional burden of governmental reporting, both adding to costs over time.

Good relations with investors can be maintained only by keeping current with information between the company and the investors.  If there is a concern over some investors gaining a competitive advantage, the amount of information may be reduced to the minimum for some classes of investors.  A good example of this is the information provided to common stock holders, many of whom may be former employees who have exercised stock options and moved on to join the ranks of the competition.

Of course, a public company is not entitled to pare its information to reduce exposure to competitors.  That is one of the many costs of becoming a public entity as many CEO’s have found and dealt with over the years.

Some businesses just can’t fit within the angel capital or friends and family model for raising funds.  Sooner or later these businesses will have to seek venture capital and accommodate the needs of the venture community in negotiating the terms of an investment.

First, VC’s in general cannot invest in ‘S’ corporations or limited liability companies (LLC’s).  This is only a minor problem in that both forms can convert easily into ‘C’ corporations at low cost and little consequence.

More importantly, VC’s will worry over a number of issues when looking at a company and deciding about an investment.  Is the price paid for shares by previous investors excessive, creating a post-money valuation too high for the actual value of the company?  If so, the VC will contemplate a “down round” – that is: offering an investment where previous investors find their investments instantly worth less than their original value, even if the investments were made at high risk and years earlier.  No one wants to face this, but the need for money and the possible overpricing of the first rounds may have created an unsustainable valuation.

[Email readers, continue here...]  Second, it is important in the first investment round to face the issues that may be required later by subsequent, more sophisticated, investors such as VC’s.  These include “tag along rights” which allow investors to sell some shares when others, such as management or founders, sell any shares.  Also included are “drag-along rights” in which minority shareholders may be forced to obey the vote of the majority in such important votes as to sell the company or take a round of financing at lower share prices.

Most VC’s today are becoming enlightened (as are organized angels), correctly forcing many decisions that might have been dictated by investment documents instead to the corporate board to decide.  This allows for a discussion – and perhaps a negotiation – between inside and outside board members in such instances, all for the good of the corporation, not just one class of shareholder.  You may recall that board members have a “duty of loyalty” to the corporation, not to their constituent investors.  This enlightened thinking reinforces that duty, even sometimes at the expense of profit to the VC’s.

Guest post by Sara Mackey

Dave’s Note:  This is the first time we’ve had a guest author on the BERKONOMICS site.  Sara focuses upon another side of small business financing not typically considered in the angel and venture world, financing from sources for companies that will probably never be attractive to those niches. 

So, you’ve been thinking about starting your own firm for the past ten years.  Your business plan is ready.  Your family is all for it.  You have enough in savings to get started, but how and where do you go to find additional funding sources?

The times have changed, and many of the sources available in the past have become risk averse or moved on, but there are new alternatives.  There is still abundant money available for early stage investment, but many of the rules have changed, as well as the processes for accessing these resources.

Here’s the new truth: It is rare to get anyone to invest in an idea these days.  The great majority of investors who did invest in “idea stage” businesses, lost fortunes when the Internet “bubble” burst at the beginning of the last decade.  Many of those investors, individual and institutional, are still licking those wounds; and as a result, investors today want to see a working business model, and customers that are willing to spend good money for your specific solution.

Another fact: The “uninformed” small businessman usually tends to approach the most difficult funding sources first, wasting an inordinate amount of time, and then failing to raise any funds, making his or her situation more serious in the process.

[Email readers, continue here...] When searching for funding, one of your primary tasks should be to start where it is easier, and proceed from there.  So here is a brief list in ascending order of time and process difficulty:

Friends, Family and Business Partners:  Your journey should begin with people that know you, trust you, and believe in your business ability.  If you cannot convince them to invest in your plan, then why would anyone else even consider a proposal to invest in someone that they did not know?  Start here, and then move on.

Local Community Bank:  Big banks rarely lend to small businesses, but small community banks do, usually with collateral and personal guarantees.  You want to establish a relationship here to gain access to their network at a later date.  They can also help you with an SBA (Small Business Administration) loan, if that path is correct for you.  If you already have high-limit credit cards, these happen to be the preferred funding source for most small businesses today.

Independent Third Parties:  This area for securing business loans has witnessed the greatest degree of change, primarily due to removal of communication barriers using the Internet.  There are a host of companies that can be accessed through web-search engines that can provide both secured and unsecured financing.  Factoring companies can help you with working capital needs when your business grows quickly by filling the money “gap” created between new billings and actual collections.  Small businesses typically underestimate this need.

For unsecured loans, the universe of options is broad.  If you are in retail, then a merchant cash advance may help you and grow with your business.  Fees may seem high at first, but, on a total cost basis, these funding sources can appear more reasonable.  Credit risk related to small business is heightened in tough economic times, the reason most banks refuse to support this arena.  Most economists, however, purport that our recovery will never stabilize until small businesses can access capital, hire new employees, and grow.

Crowd Funding: The Internet is at work here, especially for obtaining early stager seed money.  An entrepreneur utilizes online communities to solicit pledges of small amounts of money from individuals who are typically not professional financiers.  Research the Net for guidance in this arena, which is changing as laws enabling this are evolving.

Venture and Angel Funding Sources:  Business loans or capital raises are very difficult to arrange in this area, unless the business has a potential of growing to over $50 million within five years, and usually is able to demonstrate that it has protectable intellectual property of value.  Competition is high for these resources, and often there is a substantial ownership stake, if not control, for the investors, depending upon the value of the business and success in using the first moneys invested. If your business does not fit into these parameters, it is better to focus on other options.

Sara Mackey is the marketing director and a client manager for Connexx.com, an authoritative guide in the field of small business financing.  She has worked with start up companies for nearly a decade in helping with the development of business plans and securing financing.

For those of us who’ve invested in early stage companies, especially technology startups, 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 startups 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 startup 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.

[Email readers, continue here...] 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.

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:

If Exists:                                                 Add to Company Value up to:

1. Sound Idea (basic value, product risk)            $1/2 million

2. Prototype (reducing  technology risk)             $1/2 million

3. Quality Management Team (reducing execution risk)    $1/2 million

4. Strategic relationships (reducing market risk and competitive risk)   $1/2 million

5. Product Rollout or Sales (reducing financial or production risk)         $1/2 million

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

When you seek professional investors, whether organized angels or venture capitalists, one of the early questions you are asked is “How have you financed the business so far?”  Investors love to see entrepreneurs who have used their own money to ignite their businesses.  But often, entrepreneurs turn to others for initial capital. Describing that capital using the phrase “friends, family and fools,” or “FFF,”   has become as common as to be trite.  And even more recently, “crowd sourcing” has been enabled by the Internet – seeking many investors at a small amount per investment.

The problem in taking such money rests in the legality of taking money from non-accredited investors, people who do not meet the SEC standard for making non-public company investments.  Currently that standard requires a minimum of $200,000 in annual income or over one million in net assets, including the value of the investor’s principal residence.  Since many small investors in a young business do not meet that standard, there is a chance that the company has taken money that it should not have taken, according to SEC rules.  There is an exemption for members of the entrepreneur’s family and in some cases for close friends with intimate knowledge of the entrepreneur and of the plan and, of course, for employees of the company.  It is worth checking with an attorney to see if such investors are truly exempt.

[Email readers, continue here...] Some small companies work to create “private placement memorandums,” attempting to protect themselves against this problem, couching the proposed investment in legal language stating the risks involved in making the investment.  The PPM does nothing to mitigate that problem when the investor is not accredited.

To compound the problem, often stock is issued by the entrepreneur without filing any report of such issuance with the state of issue.

The sum of these problems is that a disaffected investor can sue the entrepreneur or the entrepreneur’s company for a rescission of the investment and return of the money invested if the money was taken improperly, especially when the business has failed and the investment lost, putting the entrepreneur at risk for the loss of additional personal assets.

The cure for this, when professional investors enter the picture, is for the company to craft a “rescission offering” to those shareholders who invested illegally, offering to repurchase their shares at full value invested.  This is sometimes difficult since it often happens just at the time a company needs new money most and is in the process of seeking that money for growth.  If a previous investor does not accept a rescission offer, there is some insulation provided to the company against a future lawsuit by that investor.

So, plan to take money only from qualified investors. Check with your attorney if there is any doubt.  The risks of a problem rise with unmet investor expectations, and fade with success.  But sometimes, such behavior will cause a subsequent angel or venture capitalist to pass on an otherwise good opportunity, and that would be a shame, one that could have been avoided by diligent process in the early investment cycle.

I cannot tell you how many times I have seen executive summaries of business plans in which the entrepreneur seeks $5,000,000 to build the business.

First, few startups can use that much money today with all of the virtual services available and increasingly inexpensive methods of development, prototyping and marketing. Second, almost no professional investor will consider putting that much into a startup until there is proof of market demand, product viability or some other mitigation of failure.

Third (if you’re keeping score), it is not wise to dilute the founder’s ownership greatly in the first round of financing.  The investors want a motivated entrepreneur, and it is certainly more difficult to motivate a twenty percent owner than a sixty percent owner.

Fourth, there is the matter of control.  Entrepreneurs have a vision for what and how to create and build a great business.  Giving control over that vision to others early on often dilutes the vision and is a disincentive to the entrepreneur.

[Email readers, continue here...] Professional investors love to see companies where the first round of financing came from the entrepreneur, showing “skin in the game” and more motivation to succeed because of money invested as well as time and creativity.

There are so many resources for early money to validate an idea, turn it into a product and increase the value of the company before professional investors come into the picture.

Starting with credit card debt or a personal loan and working through money from friends or family, or simply consulting to earn money for investment, entrepreneurs should consider early resources for capital to produce a prototype, do market research or start to build a team.  Once there is progress in any of these critical areas, raising professional investment is easier and the likelihood of a higher valuation makes for retention of more equity during the first important professional round.

                Early stage investors have been arguing over this for years.  Do they bet on the entrepreneur (jockey) or the business idea and plan (the horse)?   This is serious stuff.  If you are looking for money, this question will certainly come up in one form or another when you approach professional or organized angel or VC investors.

                My answer always varies as I examine each deal, sometimes deferring and passing on an investment because of an uneasy feeling about the entrepreneur, even if the business plan seems able to capture the market.  Speaking for others, I see VC investors jumping into deals knowing that soon they will push to replace the entrepreneur with a professional, experienced manager that the VC has vetted and trusts.

                I have bet on the entrepreneurial jockey a number of times and been blind-sided by after-investment behavior that completely reversed my opinion about an entrepreneur’s ability to manage growth to breakeven.  Other times, the entrepreneur went on to assemble a great team and execute the plan as it inevitably changed again and again.

[Email readers, continue here...] Although this debate will continue for ages, I tend to fall on the side of betting on the jockey, simply because it has been a rare business plan that did not change again and again seeking a successful model in the marketplace.  And great management is able to morph a company to adopt without destroying the culture of the company in the process.

                What if you were the investor and someone walked into your office handing you a business plan executive summary that floored you with its brilliance?  And what if that person admitted immediately that he or she had no team and was not the person to take this plan to market?  Would you, as an investor, plow money into the plan and help to incubate the idea into a real enterprise?  I would not, nor would most all of those I co-invest with.  There are millions of great plans that failed over the years for want of a great management team.  And I am sure there are many, many average plans that developed into great companies with the help of a great team.

                So if you are one of the entrepreneurs without experience or ability to take your great plan to market, admit this early and form a team that investors can trust to do this, personally stepping into a position that fits your core skills, be it marketing, sales, development, or other areas required by a young company.  

                It would be refreshing as an investor to meet an entrepreneur with a great plan and a pre-formed management team fronted by the strongest possible leader, even if the entrepreneur offers to take a back seat in order to make the vision a grand reality.