Posts from Finance

No this is not a post about yoga, although I am really looking forward to my yoga class this morning. It's about the two concepts in finance that I think are most important for folks to understand.

The Gotham Gal and I went out to dinner with our oldest child Jessica last night. We got into a deep discussion of personal finance and how to manage it. I was talking about the difference between how much you make and spend and how much you have in the bank. I wanted to talk about the P&L and the Balance Sheet but I did not want to use those business concepts. So I called them the flow and the balance.

The flow is how much you make and how much you spend. It is the flow of money in and out of your bank account each day, week, month, year, etc. The balance is how much money you have in the bank (or any other form of account where you can have money on deposit).

We talked about how you could have a balance of $10,000 and because your flow is negative (you spend more than you make), that balance could go to zero over time. And we talked about how you could start with a balance of zero and because your flow is positive (you save money each month), your balance could grow to $10,000 over time.

As we were talking, I was reminded that unless you major in economics or finance, high school and college doesn't prepare you for the world of personal finance. Jessica has most of the tools she needs to manage her finances and she has been doing it for a while because we make our children responsible for their spending as they become young adults. And yet, she found this distinction between flow and balance helpful to understand as she prepares to get out of college and take even more control of her personal finances.

The generation that my kids belong to will have some incredible tools as they start to take control of their own finances. Online banking and web and mobile based personal finance tools that take advantage of the portability of your personal finance data are evolving at a fast and furious rate. But to use these tools, you need to understand and make sense of the data. I think simplifying and demystifying these concepts and this data is key. And I wish that there were more educational resources available to young adults as they enter the working world to help them with this stuff. It's important.

Today on MBA Mondays we are going to talk about the financial leader in an organization. Sometimes this person is called the VP Finance and sometimes they are called the CFO. What is the difference? When will a VP Finance do? And when do you need a CFO?

Like all titles, they can get mangled. A person might be promoted from VP Finance to CFO without exhibiting the characteristics I am going to ascribe to a CFO. That happens all the time. But if you really need a CFO and you have a VP Finance, you will know the difference.

A VP Finance is what you need when you want a leader who will keep the wheels on the bus, who will make sure there are financial controls in place, who will make sure the books, records, and reports are accurate and timely and well presented, and who will make sure you have the right amount of accountants and clerical staff on hand to manage the work of the finance organization. A VP Finance is largely about "what happened" and a little about "what is happening right now?"

A CFO is what you need when you have all that I described above but you also need a forward looking financial mind at your side, when you need deep strategic thinking in the financial function, when you need to do big transactions (both M&A and financings), and when you need someone to manage your relationship with investors (particularly public investors). A CFO is largely about "what is going to happen and how do we get there?"

I generally encourage companies to wait as long as possible to bring on a CFO. Great CFOs are few and far between. And in order to recruit one of them, you will need an interesting business and a meaty role. VP Finance talent is in larger supply and they can take you very far. Get a VP Finance onboard as soon as you can afford one. They will let you sleep at night. Get a CFO on board when you are ready to take on the world. You can't do that without a strong one at your side.

Back when we were doing our MBA Monday series on Financing Options For Startups, I got an email from my friend Andy Sack. Andy was one of the first entrepreneurs we funded by in the mid 90s with our Flatiron Fund. He's done something like a half dozen startups since then and he's a veteran in the very best sense of the word.

Andy said "You missed an important option Fred – revenue based financing. I've got a new firm called Lighter Capital that does just that". I said, "Can you write a blog post for MBA Mondays explaining how it works?" So today, we have a guest post/advertorial on Revenue Based Financing from Andy/Lighter Capital. I hope you like it.

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Fred’s series on alternative financing options has been awesome to follow, especially because it broadens the discussion of how companies can fund business growth when they can’t (or don’t want to) raise venture capital or bank debt. Fred’s original list missed one option – revenue-based finance – that's near to my heart and I’ve been encouraging entrepreneurs and angels to consider, and Fred graciously let me offer my insights here.
 
Disclaimer: I am founder of Lighter Capital and have a self interest in educating and promoting the use of this new type of financing called revenue-based finance.  I’m also a serial technology entrepreneur and believe this type of financing has real advantages to traditional debt and traditional real advantages over equity for the entrepreneur.

A revenue-based finance (RBF) investment provides capital to a business by “selling” an ongoing percentage of a company’s future revenues to the investor.  For simplicity, you can think of it as a revenue share type of arrangement. Investor gives capital to company in exchange for a small percentage of gross revenues. RBF lives as a hybrid of bank debt and venture capital. This kind of financing has been around for a while in non-tech industries such as mining, film production and drug development, but it’s recently been gaining traction in the world of growth finance and early-stage technology funding.
 
I want to explain how an RBF structure is different than traditional funding sources, detail what situations could be better suited for an RBF structure (for entrepreneur and investors alike), and offer a word of warning about the businesses that aren’t a good fit for the structure.
 
First, let me explain how a revenue-based loan works:

Instead of a typical bank loan which requires a business to pay a fixed interest payment, a revenue-based loan receives a percentage of revenues over a specified amount of time, allowing "interest" payments to fluctuate when a growing company has inconsistent cash-flows or lumpy or seasonal revenues. In a world where business costs such as software and infrastructure are increasingly becoming “as-a-service” and adjust with the ebbs and flows of a business needs, RBF payments automatically ramp up and down along with a business. It’s the inherent variability of RBF that makes the structure so appealing so appealing.  Imagine if your business loan payment reduced to zero if your business revenue dropped to zero for an unanticipated quarter, and then automatically kicked backed on when your revenue returned. Another way of saying this is RBF turns loan repayment from a fixed expense to a variable expense.

So, when does it make sense to raise revenue-based funding?
Revenue-based loans are, by nature, most appropriate for companies already generating revenues but without hard assets typically required to get bank loans. It’s especially applicable for companies that have lumpy, seasonal, or hard to predict revenues.

 
For entrepreneurs, revenue-based loans are attractive to founders who are allergic to dilution and loss of control.  The structure of RBF is often non-dilutive to founders and does not require a board seat. The financing is obtained without having to agree to a valuation, which leaves management in control of the company and typically requires no personal guarantees from management.

RBF means you can grow without swinging for the fences

For investors, funding using an RBF structure provides an opportunity to get a return on their investment without needing an exit. While this is clearly an advantage for investors, it also means company founders shouldn’t get as much pressure from investors to “swing for the fences” and the projected return due to the investor can be lower as the entrepreneur repays the investor more quickly.

As Fred has mentioned before, big exits are rare for startups. Some ideas have the potential to be home runs, but others are better suited to operate as smaller, standalone businesses. For the companies in the latter category, raising money from VCs who expect the big exits can misalign goals. A revenue-based loan has the potential to better align incentives for investors and founders in these cases. With that said, if you’re a pre-revenue, startup still figuring out your business model or considering some kind of “go big or go home” strategy, there can be realadvantages to working with the equity-based venture capital or angel investors. Similarly, certain businesses, especially brick-and-mortar and manufacturing-focused businesses may not have the margin profiles to pay monthly payments of 2-5% of revenues.
 
An RBF structure isn’t limited to specific funds – angels, VCs or banks could theoretically provide capital in this manner, but the risk/return profile of RBF doesn’t always fit the investor’s needs. Similarly, RBF may not be the best funding option for all businesses. In the right circumstances, the hybrid approach of revenue-based finance for startup funding can have advantages over traditional debt or equity, but there are admittedly situations where the more traditional options still make sense – such as restaurants or infrastructure-heavy startups.
 
If you’re considering raising money from angel investors, I’d suggest discussing this in the event that it may align your incentives better or at least help avoid some of the painful valuation negotiations. There are a few funds –Lighter Capital and Next Step in Texas, among others focused on this type of structure and I’d suggest taking a look at those options as well. There are clearly different scenarios where any number of Fred’s financing alternatives could prove more appropriate for your business, but the revenue-based loan structure can be a great option for profitable companies looking for a straightforward way to raise funding without dilution, change of control, or a personal guarantee.

We are coming to the end of the Financing Options series. This is the final post in the series. Today we are going to talk about working capital financing.

For those of you not steeped in finance and accounting matters, I suggest you go back and read the Balance Sheet post before reading on. Working Capital Financing relies on a company's balance sheet to support the loan so understanding how a balance sheet works is important to understanding working capital financing.

As a company grows, it starts to consume a lot of cash in the day to day operations of the business that has nothing to do with its profits or losses. This type of cash consumption is called working capital. In accounting terms, working capital is equal to current assets minus current liabilities. In layman's terms, working capital is what your customers owe you plus any inventory you have built up minus what you owe your suppliers and employees. Working capital also includes any cash you have in the bank.

One of the many awesome things about a software business is that it rarely has any inventory. But for the purposes of this post, we need to think about a business that has inventory because inventory buildup is a big reason that companies consume working capital.

Let's think about a company that makes iPad stands like this one (I have it, it's awesome). Let's say it costs $25 to manufacture one iPad stand. Let's say you have orders for 10,000 of them at a wholesale price of $40. So you need to  come up with $250,000 to produce the inventory to meet the demand. Then you ship the iPad stands to Amazon or some other retailer. And then you wait 60 to 90 days to get paid the $400,000 by that retailer.

On paper, your business looks great. You have revenues of $400,000 and costs of $250,000. You have profits of $150,000. But you cash situation is horrible. You are out $250,000 and you are going to wait 60 to 90 days to get the $400,000 from retail. And you've got another order but this time it is for 20,000 units. You need to come up with $500,000 to meet demand.

This is known as a working capital issue. The business is making plenty of money on paper but can't manage its cash needs. And the faster it grows, the worse it gets.

This is exactly the situation working capital financing was designed to deal with. Banks and finance companies will loan companies, particularly profitable companies, the money they need to purchase inventory and wait to get paid by their customers. Banks will rely on the purchase orders on hand and the actual value of the inventory that the company has in stock to backup the loan. They will also take into account the money the company owes its suppliers and employees in determining exactly how much capital to loan the company.

Most working capital financing has built in cushions. Banks will not loan 100 cents on the dollar of working capital. They might loan 75% or 50%. But as working capital grows, they will increase the size of the loans they make. These are all short term loans because the inventory eventually gets sold and the customers eventually pay. A typical way these loans are structured are lines of credit and revolvers meaning that as the money comes back into the business, the loans get repaid, but the total amount available under the loan stays the same so the company can just borrow it back when it needs the money again.

For companies that are particularly shaky, there is a technique known as "factoring" where the bank actually takes the amounts of money due from the customers as collateral and gets paid directly by the customers and then remits the extra amounts to the company. The bank essentially becomes the accounts recievable department of the company. Back in the dark days in the aftermath of the crash of the internet bubble, I got a bank to do this for one of our portfolio companies and it was the only way we got through a major financial crisis.

Even a software based business can build up a lot of working capital. It ususally results from the company having to pay its obligations much faster than its customers are paying the company. If you have customers that pay in 90 days and you are growing revenues quickly, then you can find yourself in a major cash squeeze. Working capital financing is a great way to manage that kind of cash squeeze.

Today on MBA Mondays we are going to cover yet another topic in the Financing Options series, financing capital equipment like servers, routers, switches, computers, etc.

Equity capital is expensive. Every time you do a raise, you dilute. It makes sense to look for places where you can use other less expensive forms of capital to fund growth. As we talked about in the last post in this series, I'm not a fan of debt for an early stage startup because there is no obvious way that the debt is going to get paid back. But capital equipment provides an opportunity for debt financing because you can borrow against the equipment. There are two primary ways to do this, capital equipment loans and leases.

Capital equipment loans are loans made by banks and finance companies to provide a company the funds to aquire the capital equipment. The company owns the servers, computers, etc and puts them on its books. The company also has a loan obligation on its books to the bank or finance company. The loan is collateralized meaning that if the company defaults on the loan, the bank or finance company can come take the equipment. The equipment is the security for the loan. These loans are usually self amortizing term loans of around 3 years and carry interest rates of between 6% and 12% depending on the financial profile of the borrower.

Leases are a financing tool used by the manufacturers of equipment (and sometimes by banks and finance companies too). Let's use Dell in this scenario. You want to purchase a bunch of Dell servers to run your web application on. Dell can lease the servers to your company instead of selling them to you. Under a typical lease deal, you will pay the lessor (in this case Dell) a fixed monthly amount for a fixed term, typically three or four years. At the end of the term, your company will have the option to buy the servers for a nominal amount or give them back to the lessor. Some leases will be capitalized and end up on your books and look a lot like capital equipment loans. Other leases will not end up on your books and will look more like renting an office.

In both cases, you are getting capital you need to finance growth (in this case servers and related capital equipment to serve your growing user base) without diluting. And the primary reason for that is the equipment itself provides the security for the loan, not your company, which is likely not credit worthy.

I am a huge fan of this form of financing for startup companies. The risks and rewards are well aligned for both the lender and the borrower and it makes sense for both parties to do these transactions. Don't use your precious funds raised in dilutive equity rounds to buy servers and other capital equipment. Go see a bank, finance company, or manufacturer about a financing arrangement. It's the right way to finance these kinds of growth needs.

Last week's financing options post was about getting your customers to finance your business. This week's post is about getting your suppliers to finance your business.

Truth be told, this is not very common in the startups I work with. The more capital intensive your startup is, the more you can and should think about this approach.

Two reasonably common examples of vendor financing in the world of tech startups are equipment financing and development for equity.

Equipment financing is when a vendor of capital equipment, like servers, agrees to sell you their product and takes a loan or a lease instead of cash. We are going to do an entire post on capital equipment loans and leases later in this series and we will cover that in more detail then.

Development for equity is when a third party development firm builds something for you and takes equity in your business (or less commonly, a loan) in return for the development services. It is fairly common for a development partner to take some of their compensation in equity but it is rare for them to take all of it that way. But in this case, a vendor of services to your company is financing your business by reducing the amount of cash you need to lay out to get into business.

In the biotech and cleantech sectors, vendor financing is more common. These sectors have large capital equipment requirements and large third party services requirements. There is a lot of money laid out to third party vendors on the way to cash breakeven and therefore a much greater opportunity to have those vendors finance the business.

When you are starting a company, cash is always tight and so anytime you need a third party vendor to supply your company with services, you should be thinking of vendor financing possibilities. It can be a great way to keep your cash outlays down when the cost of capital is highest.

I wrote in an earlier post in this series that friends and family is the most common form of startup financing. If you are talking explicitly equity investments, then that is probably true. But the most common way that startup businesses get money to get going is they sell something to someone. In this context, someone means customers.

Customers are a great way to finance a business for many reasons. First, customer financing is typically non dilutive. They want something from you other than equity in your business. Customers also help you fit your product to the market. And customers will help debug and improve the quality of the product. An early customer will give you credibility with other customers. And an early customer may spend more with your company down the road.

The most common way customer financing is done is you sell the customer on the product before you've built it or before you've finished it. The customer puts up the money to build the product or finish the product and becomes your first customer. Usually the customer simply wants the product and nothing more. At times an early customer might ask for some exclusivity on the product or even some free equity in the business, but most of the time the early customer simply wants the product from you and nothing more.

So why not take this approach with every startup? Well, it isn't always possible to find a customer who will put up money in advance of the product being complete and ready to use. It takes great salesmanship to convince a customer to buy something from you that isn't built or isn't finished. But even if you can convince a customer to do this, there are some negatives.

First and foremost, building a product explicity for one customer often makes it less applicable to the market as a whole. An early customer who provides funding to build your product will want the product tailored specifically for its needs. And a highly tailored product is often not well suited to a broader market.

Second, you risk building a "fee for services culture" in your company with this approach. Some companies build products for customers for a fee. Other companies build products and sell them "as is" to customers. The latter is the scalable model for building valuable companies. If you use customer financing, you risk being pulled into the former.

And customer financing is much more difficult, if not impossible, in consumer facing services. It is much more applicable in business facing services.

Those are the pros and cons of customer financing. If you can convince a customer to put up significant capital in advance so you can build or finish your product, you should consider it very seriously. Many great companies got their start this way.

This is the first in a series of posts about financing options for startups. By "financing" I mean obtaining cash to fund your business. There are all sorts of strategies to avoid needing funding, but this series is not about them.

Many entrepreneurs turn to friends and family for their first funding needs. In fact, it is common for non-tech startups to raise all the capital they need from friends and family. I don't know for sure, but I would suspect that friends and family make up the largest source of funding for entrepreneurs and startups.

Friends and family financing is popular because it is easy to get a hearing from the people who know you best and they are positively inclined to say yes. But there are some negatives as well. It's tough to know how to price and structure an investment where the investors are close friends or family. You don't want to take advantage of them and they may not be sophisticated enough to know what is a good deal and what is a bad deal.

And friends and family often cannot come up with a lot of capital so unless your business doesn't need much funding, this will not be the only round you do. But friends and family can get you into business and give you some time to create value that other investors will recognize and value.

Probably the most tricky part of friends and family financing is that you really don't want to lose money that friends and family have invested with you. And most startups fail so the chances that will happen are high. I would encourage entrepreneurs who take funding from friends and family to be very clear about the risks and downside. I would also suggest only taking capital from friends and family members who can afford to lose the investment. That way, if the investment does turn out to be bad, at least you won't lose valuable relationships. Even so, it is easier on the mind to be doing a startup when your capital comes from professional investors than your loved ones.

I would recommend doing friends and family financings as convertible notes with a discount and a cap on the valuation. That way you don't have to worry about how to price the investment. A 20-25% discount from the next round is appropriate. The valuation cap is going to vary depending on the size of the raise and the size of the opportunity. I'd suggest a cap that gives the friends and family around 10% of the business if things work out. But that is just a suggestion. A 10% interest will not be appropriate for every friends and family investment.

Friends and family funding is the most common form of startup financing but also the most tricky in many ways. Be careful to do it right because there's a reason why these people will back you when nobody else will.

I got a bunch of great suggestions in my kickoff post on this topic last week. Based on that feedback, the series is going to look like this:

1) Friends and Family

2) Contests/Prizes/Accelerator Programs

3) Government Grants

4) Customer Financing

5) Vendor Financing

6) Convertible Debt

7) Preferred Stock

8) Venture Debt

9) Capital Equipment Loans & Leases

10) Bridge Loans

11) Working Capital Financing

This list is roughly in chronological order of how a small company might avail itself of the various financing options, but there are always exceptions. Starting a company is more art than science.

I want to do each financing option as its own dedicated post so I’m not going to start today. I will start next week with friends and family.

If you are looking for some meaty MBA Monday reading this week, I point you to Brad Feld and Jason Mendelson’s awesome venture capital term sheet series, which is required reading for anyone seeking to raise venture capital.