Archive for January, 2010
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…
Have you ever driven a car that had no speedometer? I had that thrill when a student at the Richard Petty Stockcar School of Driving recently at a motor speedway in California. With a wide track, angled aggressively at the curves, and being told to hug the wall on the straightaways, there was little reference available to a novice driver as to speed. I followed my instructor’s car closely, but still could not tell anything about my speed, so that I could either compensate for lags behind the leader or a test my comfort zone at various points that matched the expectation of my instructor and my own increasing capabilities as a driver. Upon conclusion of eight laps of this, after pulling into the alley and climbing through the window on the driver side (there are no doors in these cars), I was handed a sheet with my timings for each of the eight laps. Only then, after when the information might have been useful, could I see how well I did.
That’s how you would feel if you ran your company without a dashboard containing relevant metrics that drive your company. If you cannot relate to this, then you probably have been driving without a speedometer from the start and need to pay particular attention.
[Email readers continue here...] Metrics should be created by you and your managers to measure near real time progress for your enterprise. A number of these deemed critical to you and your managers should be combined into a single page on your desktop screen or in printed form and available or circulated as often as daily. These measures of progress must be fresh and meaningful. Yesterday’s sales and returns compared to same day last week and last year for retail businesses; Units produced and units shipped compared to plan and same period last month for manufacturers; Yesterday’s overtime hours by department; Ratio of hours worked to units produced; Backorders unshipped; Customer service calls in cue or unresolved.
You can think of numerous critical measures for your business that must not be ignored, but often are neglected by senior management. It is not bad to manage by walking around, a term that became popular as a result of another of the many business advice books of the ‘90’s. But that method, although good for employee morale, is imprecise as a tool of measurement and should be relegated to a supporting role. Financial information for last month compared to plan and same month last year is certainly relevant, but not part of a dashboard, since there is nothing you can do to fix a problem when numbers are as old as a week, let alone the typical several weeks required to prepare financial statements for review.
Finally, what good is the information contained in a great dashboard if you ignore it? Show that you value the information by acting immediately upon variances, even if only to question the numbers. Everyone down the line will become aware of your attention to their work, your interest in the outcomes and care for their success. And you will drive revenue and better control costs and the customer experience with quick reaction to the variances within critical metrics the best describe your immediate situation.
Let’s spend a few moments defining a sometimes confusing set of terms. A budget should be created each year as a result of a series of negotiations between departmental managers and their superiors through to the CEO, all in support of the next year’s tactics previously agreed upon (which in turn support the longer term strategies leading to the next goal beyond).
So a budget sets the limits upon spending for the next year that are negotiated between the players. An important part of the budget is the expected revenue for the coming year, a critical factor in setting hiring and resource expectations for the year. During the year, if the forecast revenues fall short or are greatly exceeded, it is fair to revise the budget and rethink hiring and resources. Otherwise, it is the expectation of the board of directors of a company that each year’s budget be approved in advance and adhered to as long as revenue goals are met.
[Email readers continue here...] Note that I used the term “forecast” for revenues for the next year. The term is also used when projecting revenues for succeeding years. The term “forecast” is a bit confusing, because it is also used by some as a measure of expected revenue and expenses to the end of the current year, found by taking actual performance year-to-date and adding best estimates of remaining revenues and expenses for the rest of the year to obtain an expected or “forecast” outcome at yearend. Both uses of the term are common. Just be sure all who participate understand which use of the word is the current one.
The real point here is to create a financial plan to support the strategic plan, marrying them in harmony one with another. Many entrepreneurs are impatient by nature, not the best of detailed planners. Yet, with the assistance of those in support such as the CFO, everyone in management must be aligned in a single direction, reviewed and updated annually as accomplishments, the marketplace, and even the competitive landscape change.