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Picking Ventures: Part 2

Sometimes the dog really does eat it.  And sometimes it's a big dog.  Tom Perkins, in telling the Tandem Computer story says "when the first product performed as expected, the company went to $100MM very quickly."

We all have heard/repeated the investment mantra about "big, growing markets" with "unfair advantage IP" position.   And I'd like to think that's a great place to start when thinking about ventures.  

But it just doesn't happen that way as often as we'd like to think. 

When we talk to entrepreneurs (or explain to others what we do) we often explain this in risk terms.  Will the product work? How do we know how much the customer will buy and how long it will take?  How big is the customer problem being solved?  Are we displacing a major competitor or a lot of smaller players? How disruptive will this be, and therefore, how fast might adoption be?  

It's not very often that all of these forces come together at the same time - as they did with Tandem Computer - and the company's growth explodes.  

But that hoped-for explosion only the beginning.  The company's ability to go to scale rapidly and (relatively) efficiently is going to be a very big part of any future success.

Growth generated by market demand and sales can be very complex.  

Growth financing, for example.  Investors would like to see lowest cost - but with certainty.  That can mean a variety of venture debt-type structures - but servicing and cash flow will be really important.  Working capital lags mean delivery lags.

Hiring the right folks with broad experience beyond what is immediately called for is a great idea - if you can find then and if they'll work well with the entrepreneurs. 

We often forget that the first CEO at apple was -- Mike Scott - not Steve Jobs.  Mike Markulla came with the first investments - as a cofounder -- because investors felt the company needed leadership that could attract talent to be able to grow and he brought in Scott.

And manufacturing - most of the time means outsourcing.  If the market demand ramps quickly enough there isn't enough time to consider much else.  This again involves a complex series of skills and challenges.  

And then the partners come calling.  And that leads to all sorts of legal structuring issues.  Making early long term promises to solve short term problems can often lead to real indigestion later on.  

When an investor thinks about these issues, leadership is really the central inflection point.  

An enthusiastic, capable, singleminded leader with an orientation to overcommunicate and build great teams dedicated to the growth process is perfect.  

 

Picking Ventures: Part 1

 

Making educated guesses about which new ventures to invest in, truth be told, is a process prone to lots of error.  "A venture investor who never loses isn't risking enough," said a friend of mine recently.  We all can tell stories of investors who missed the big opportunities ("who really needs another search company?) and invested in, well, interesting ventures. ("We can ship pet food across the country via FedEx and make huge margins!!!")

Every entrepreneur who's ever talked to investors knows there are a couple of different things going on.  The one that's obvious - what the product is, etc. -- is the least important.  The bigger process is the tenor of the interchange.  

In broad terms, when I look at an opportunity, I'm asking myself if I or my partners understand the industry, and if our rolodex can help the company fill in the missing pieces - in growth, relationships with other companies, people and so forth. 

Nolan Bushnell finally got the home version of the Pong game to launch in 1974 because one of the venture capitalists' investors knew someone at Sears.  That opened the door in time for Christmas, and, well today video games are  - big. 

So if it's worrying that the quality of the budding relationship with the entrepreneur may not be open to that kind of help - and to coaching about all of the issues growing companies face - then maybe we should pass.

Said another way, if the entrepreneur enthusiastically seeks expertise to get to a common goal we have the beginnings of a potentially interesting opportunity. 

I'm going to flesh out some more of this topic over the coming weeks. 

 

"In a networked world, trust is the most important currency."  

     ---Eric Schmidt, University of Pennsylvania Commencement Address, 2009

How to prepare a sales forecast for a business plan

First develop a business model.  

If you've been through a plan review with someone like a potential investor, think for a moment about the questions you get asked.  

"How did you calculate the cost of goods?"

"What are your assumptions about how long it will take to get customers?"

"When do you expect the growth rate to stabilize?"

"Where do you expect to find these customers?"

"How many are there and who are the competitors?" 

"What's the current solution these potential customers are using today?"

Behind all these questions is the idea of checking and validating assumptions.  In the process of asking questions, and answering them, it's sometimes hard for this not to feel like grilling.  If the conversation goes in that direction it can be a bit of a problem.  

Think about having the same discussion in a different way - by preparing your sales forecast by making your assumptions explicit.

• Sales to segment A will be $500 per customer.   (Pricing assumption based on comparables in table 1 following)

Table 1:

    Competitor XYZ is $450 but solution takes 30 minutes to implement each time; we are less than 30 seconds and feel we would test a $50 price increase in support.  (NOTE: test concept underlies validation of the first assumption.) Etc

• COGS assumptions of 35% are based on the attached 3 estimates from contract manufacturers.  Please note that the scale required to reach these prices is 500 units per week which we will not achieve for three months (see scaling and growth assumptions following.) So for the test phase we will hand assemble first production products at $1,500 each, effectively eliminating contribution margin.  Why? Because a fully committed scale up in manufacturing will cost $450,000 and we are not prepared to do that until we have growth rate assumption risk eliminated by actual sales test results.

• Sales growth month to month is based on having an inside sales person (initially the CEO/entrepreneur) making ten calls per day.  (A full time person we think can make 50).  We hypothesize that we will get one order per 5 calls.  If this holds true for one month, we will hire and train a full time sales person who will be productive (or terminated) by month 3.  During this time the training and continued calling will be staffed by the CEO/entrepreneur.  If the calling rate holds up (and there are more than 300,000 potential customers in the industry) we will add sales person two.  By this time (in six months) we will be getting 20 orders per day from these two callers and our revenue will stabilize at that rate.  In month seven, we will begin testing additional sales strategies including direct to buyer email, google adwords, bing and social media campaigns based on our sale success. A key part of this is the positive feedback and referrals we anticipate from our users.  We will validate this assumption by direct to user contact from the CEO/entrepreneur during months two-six. 
• Here are the assumptions about our expenses:

You get the idea.

This is also the way I'd present it. That is, I'd walk through the assumptions on each item and explain them. 

In every case, where I can get comparables, I'd use them.  Where I cannot I'd say so.  It's important to make sure that none of my assumptions are better than anything ever before achieved so that the whole financial results system is based on hypotheses that are within the realm of achievable.

This whole process avoids the common problem of sounding like you are overselling an opportunity and creating doubt when, in fact, if your assumptions are strong and your comparables reasonable, you arrive at the same numerical result with a confident and enthusiastic audience. 

Then, what about "five year" projections that everyone seems to ask for?

They're an exercise in spreadsheet math, of course.  Growth rate is based on the whoel equation of individual customer acquisition rate (like the 1 per 5 calls in the theoretical example above) the presence of alternative products or services for the target customer (did you include a Porter 5 Forces anaylsis in the presentation?) your ability to scale your sales efforts, future costs in acquisition, product, etc., presence of new competitors emerging over time, size of the served market, ability to expand, etc.

I'd think that a savvy investor gets to the same place pretty quickly.  So instill confidence by your explicitly demonstrated ability to analyze and pivot your tactics and strategy, show the audience your assumptions about growth rate, and leave it.  This really gives the investor the ability to assess you the entrepreneur - which is where the decision is going to inevitably end up. 

 

 

 

How should I finance my new venture?

It’s a deceptively simple question:  what is the optimal way to finance a new startup?

And the answer is also devilishly simple: It depends.

Align Everyone’s Interests

This seems like an easy topic – debt where there is appropriate cash flow, equity when there isn’t.  But details in each category vary dramatically.

The overarching idea, of course, is to reduce the cost of capital while maintaining appropriate flexibility for the venture. 

And, while debt is less costly than equity, it can bankrupt a company more quickly than more expensive equity might.

Business success is the ultimate goal. But, what constitutes success for the parties involved – investors, entrepreneurs, employees, and customers – can vary dramatically. Misaligned interests that lead to poor financing choices are often very problematic for first time entrepreneurs in young companies.  And – they can be avoided if both parties – investors and entrepreneurs – are knowledgeable and well-informed about each others’ goals and interests.

Can you bootstrap your way to positive cash flow?

When will the company have positive cash flow?  If the answer is relatively soon, then bootstrapping is a very serious consideration.  Even if it isn’t soon, early bootstrapping can reduce risk and increase chances for success, resulting in more aligned interests for entrepreneurs and investors.

 I’ve written a lot about that topic (http://www.timkeane.org/.services/blog/6a00d834560a4c69e200d83420a4fc53ef/search?filter.q=bootstrap)

 and won’t repeat it all here.

But, this should lead to a thorough, well-planned review of bootstrapping alternatives, since bootstrapping can reduce cash requirements in the pre-cash flow phase.

One common reaction to that statement, though, is the need to accelerate the business, often for competitive reasons in the marketplace. 

However, this need for acceleration necessarily occurs only after thorough, cheap and fast initial testing has been performed – and financed – by the entrepreneur to eliminate or reduce the opportunity for failure based on a faulty hypothesis.

In other words, the need for acceleration isn’t in conflict with bootstrapping – it is step two.  Sometimes, the bonus in bootstrapping is that the venture finds it doesn’t need acceleration financing.  See Greg Gianforte’s story (http://www.timkeane.org/2009/04/bootstrap-your-venture.html)

So, if time to cash flow is well understood, and estimates have been as thoroughly supported by testing as possible, then we consider two broad choices. 

If cash flow is far in the future and not guaranteed, (but early testing has proven we have a viable opportunity) then the entrepreneur probably is not going to have the wherewithal to support a current debt payment[1] structure.  Some form of patient capital will be required.  (Do not mistake the meaning of “patient” capital.  Here it only means that no debt service is required in the near term, or perhaps at all, but an agreed method for repayment will almost certainly be involved in the investment agreements.)

If, on the other hand, there is some near term prospect of cash flow (say within six months or a year) but no ability to repay in the meantime, then the entrepreneur may try and find a way to finance his “pre-revenue period” using friends and family money that accepts a somewhat lower payment in recognition of a relationship beyond just investing.[2] 

Aligning interests in structure: cost and risk

Risk in a given company varies by investor

It’s axiomatic that in a perfectly priced market, a specific level of investor risk in any business should price identically across all companies.  Things don’t work that way in the real world, of course.  One investor who has market knowledge and/or the ability to help affect the outcome may either accept a somewhat lower price since he perceives his risk to be lower, or may take advantage of comparables to obtain a higher price and make a higher return based on his added value.

What are the reasons to choose one financing structure over another?

Example one: Sustainable net operating income with some growth in a stable market. 

John has had ten years of successful experience in cabinet-making and has established a loyal following in his hometown of 750,000 people.  He sells entirely locally and bids his own work and often provides design assistance for cabinets purchased by homebuilders.  His entire income is based on his personal output and he’d like to hire several woodworkers, expand his sales to existing customers, and generate a profit in addition to his contributed labor.  He needs $250,000 of expansion capital.

First question: What are John’s plans to repay this money?  This is a critical alignment of interest question.  If he would like to pay it back out of future cash flow that leads to one set of options; if he would like to sell the business to a competitor within a fixed period of time that may be[3] another set of options.

Second question: Does John have the cash flow to support debt payments?  If he can support partial payments, perhaps some sort of accelerating payment plan might work.

Third question:  Based on the answers to questions one and two, who are the likely lenders/investors?

Possibilities:

1.  If plenty of cash flow regardless of plan for sale/retention of business:

• Senior bank debt based on cash flow coverage and new assets.  Appropriate covenants. Maybe Small Business Administration guaranteed loan.  Least expensive alternative but also least flexible.

2.   If not enough cash flow but with the desire to retain the business --

• Insider junior debt with annual or quarterly payments beginning at the appropriate time - year or so? -  based on available free cash flow up to some sort of limit – i.e., 2x in three years – then a percentage of the cash thereafter, as in 3% of revenue – up to a limit and then a fixed price buyout.  This would imply a recap.  More expensive than #1 but more flexible.

3.  If even less cash flow but with the desire to retain the business:

• Friends and family money on junior debt terms.  About the same cost as #2 but more flexible if repayment terms slip a bit.

4.  Cash flow levels inadequate as in #2 and #3 but desire to sell the business:

• Junior debt with a variable repayment schedule based on available cash (i.e., 85% of all available cash goes to debtholders until they get 2x back, then some percentage of the business proceeds go to them at sale of business within a fixed period of time, (i.e., five years.)

Example two:  Explosive market share growth and revenue in an expanding market with acquisitive players available.

Sarah is a scientist at a national research university focused on water quality.  She has developed a water additive that purifies brown water making it suitable for drinking.  Substantial market testing has proven its scalability in use and early manufacturing tests by a major chemical manufacturer indicate it may be economically feasible from a manufacturing cost point of view.  The marketplace of buyers seems to be expanding worldwide.  The company is pre-revenue and Sarah’s intention is to sell the company within three years.

• This is an equity example, of course.  Depending upon Sarah’s ability to prove the assertions she’s made about scalability and early testing, and convince investors she or her team can deliver, she should be able to get favorable pricing and terms with all of the repayment happening at the sale of the company.
• If Sarah wanted to keep and run the company, she may be able to structure some sort of junior-debt like cash flow repayment as previously discussed.  In most cases sophisticated investors will want a larger guaranteed multiple for this kind of business.
• If in addition to keeping the company Sarah needed less than $200,000 or so, she can probably doe a more favorable terms friends and family financing.

Example three: High growth in a stable market.

John the cabinet maker has decided to expand to several cities within several hundred miles of his location, to develop several standard lines of custom products, and to seek growth at annual double digit rates.  He feels now is an excellent time based on his local experience and believes the high end of the homebuilding and remodeling market is seeking new solutions.

• This is also now an equity situation.  It’s likely the cash required won’t be repayable for several years and the risks of failure are relatively higher.  John’s former track record helps mitigate that risk but an investor perceives this as a new stretch.  Depending upon whether he chooses to retain or sell the business in the future, the same sorts of scenarios as previously discussed – probably apply.

Example four: substantial milestone-based progress that does not generate cash but will attract an acquirer or facilitate an IPO.

Angelina is an orthopedic surgeon with a specialty in hip replacement surgery.  She has designed several new devices that promise to allow arthroscopic hip replacement surgery.  Given the approval cycle required for a radical new innovation, she knows the time to revenue will be long and difficult but feels this is breakthrough technology. She needs $4MM to get the product through the normal approval cycle. 

• Aside from the attractiveness of a particular industry at a given time, this is an equity investment repaid at the sale of the company.  If there are substantial milestones that prove value as Sarah goes along she can consider raising a smaller amount at each milestone thereby increasing the value to her at each stage. She does this by reducing perceived risk for each stage of investment and finding investors at each stage with appropriately matched appetites.

None of this is exhaustive.  And I’ve avoided beginning to describe specific terms in this note.  Specific terms are an additional way that investor and entrepreneur interests get aligned in the investment process.  In addition there are several new intersting methods - royalties is one - that help in term structuring.

Note: Thanks to Bill Stone of Townbank in Delafield, WI for his comments and work in helping me prepare this note.

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[1] From a lender’s point of view, of course, the conditions under which the lender accepts a fixed interest rate in return for the promise of regular payments is based on considerations beyond the ability to repay.

[2] One of the huge mistakes entrepreneurs make at this stage is accepting friends and family money and assigning huge valuations to the company to reduce the size of future payments required.  This practice will do that, but, if other investment is ever required, the inevitability of a reduced valuation leading to a lot of heartburn is highly likely.  Always better to do this with some sort of convertible debt instrument.

 

[3] I say “may be” because if the business will support senior debt then that is less expensive and allows more flexibility whether John intends to keep the business or sell it.