In Risky Times Focus on Risk Reduction
By Scott Waxler
No matter how strong your company’s performance or outlook, no business is totally immune to macro-economic forces – those seismic elements such as gross domestic output, interest rates, balance of trade, consumer sentiment and consumer and government spending.
Whether the capital raised is from equity or debt, early stage or mature company, capital’s worst enemy is the fear of uncertainty. So what can you as a business owner do? Don’t add unnecessary risk on top of the inordinate risk already existing in the economy. Focus on tactics that reduce risk such as substantial proof of efficacy, well-defined business plans and milestones, and limit the amount of capital per raise while increasing the frequency.
Startup Equity Capital
For early-stage companies raising equity capital, the principal variables are: timing, amount, and credibility/validity of the business plan. Each of these variables is highly inter-related. The primary objective of the early-stage entrepreneur/founder during the capital raise process is to retain as much equity as possible. This is especially critical during the early stages where risk is high, value is low and most entrepreneurs are somewhat desperate for capital.
Timing, Credibility, Amount of Capital
Timing of the capital raise, the amount of the raise and the credibility of the business plan are critical variables for mature and early stage companies alike. However, early-stage companies that properly manage these variables can mean the difference between retaining a majority of ownership versus next to nothing. Too many startup entrepreneurs fail to manage the capital raise process effectively, only to be left with a small fraction of ownership by the time the company actually turns a profit.
For startups there are several value plateaus during the lifecycle of the company. The value of the startup increases as risk reduces and it becomes more evident that the business plan is actually viable without much discounting or delay.
During the early stages, it’s critical to identify these value plateaus. Each value plateau represents activities that enhance the company’s probability of success. Timing the capital raise to complement the position on the value time line is essential.
This requires an extremely well-thought plan with crisp execution. It is essential to understand when and how much to raise at each plateau, and factor time-to-market into the equation. Because most startups are sensitive about the amount of time is takes to generate positive cash flow, the issue of delaying a capital raise until the next value plateau can be achieved is always a trade off.
Timing the Raise – The Value Plateau Model (VPM)
When speaking with startup entrepreneurs, I often refer to the Value Plateau Model (VPM), which we created to better explain the importance of timing the capital raise and tranched financing.
The word “tranche” is derived from French, meaning slice or portion. In the world of investing, it is used to describe a security, either debt or equity, that can be divided into smaller pieces and subsequently sold to investors.
Tranched financing, historically used in life-science companies, has expanded into other industries. The major benefit of tranches is in the timing of deferrals, where interim milestones indicate success is coming, but does not yet bring value to the bottom line. This type of financing requires careful structuring and is unique to every company.
I tend to use terminology that generally relates to the lifecycle of technology-based products. However, the same concepts spelled out below can be applied to any product or service.
The Value Plateaus:
- Idea Inception (Seed Financing)
The first activity that generates value is the inception of an idea. Financing at this level is made to support the founder’s exploration of the idea and is known as seed financing. Value at this stage depends on several factors that include the incremental benefit the idea provides to the consumer, the amount of required investment, time-to-market, barriers to entry, and total available market size, among other elements. At idea inception, there is no proof of efficacy, so the value is very low. Unless the idea is superior, you can count on funding coming from your own pocket. Typical seed capital ranges between $50,000 – $250,000.
- Proof of Efficacy
For newly developed products, the first test of efficacy is generally conducted in a laboratory or in-house setting and referred to as alpha testing. Since there is a huge gap between lab testing and actual application of the idea in the real world, risk is still high. As with the prior step, unless the idea is a blockbuster, value will still be low. The name of the game in this stage is to have highly documented, controlled testing. At the end of this stage, a prototype may be developed.
The typical value for companies operating between the Proof of Efficacy and Beta stages that have product with attractive characteristics (i.e. relatively large total available market, defensible position, growing market, good projected return on investment, etc.) falls in the $2 million range. Another perhaps more accurate valuation method is determined by present valuing the expected free cash flow over the life of the company. Of course, the forecast itself will be questionable. Typical discounts rates are usually in excess of 80 percent. 1
- Beta (Startup Financing)
Beta testing is the last stage of testing. It generally involves controlled use of the product in a third-party, real-world environment. At each plateau there are varying levels of efficacy. With Beta testing, the highest level of efficacy typically occurs when an operator, working in a production environment, is operating the product without assistance from the product engineering team.
When this occurs, the product is typically running effectively enough to begin consumer production. At this point, efficacy is high. The investors’ focus now shifts more to operating and marketing issues, such as customers’ perceived value and the costs of manufacturing and pricing. Although still pre-revenue, if the pro-forma is consistently demonstrating a strong return on invested capital, the company value will have increased significantly. Typical discounts rates applied at this stage are between 50 percent and 70 percent.1
D. Production Stage (First Stage Financing)
At this stage, the company is filling orders for the product to be used in a production environment. The company is not profitable, but has an organization, a working product and some revenue. At this stage, the investor is very focused on product reliability and perceived customer benefits. Typical discounts rates applied at this stage range from 40 percent – 60 percent. 1
E. Repeat Orders (Second Stage Financing)
One might argue that repeat orders really belongs in the production stage. However, I believe when a customer, especially a well-recognized, respected industry player, places a follow-up order it is a substantial validation of both the product benefits and the economics.
After receiving several repeat orders from well-respected customers, efficacy becomes a non-issue. The focus changes from “Does the product work?” to “Does the company work?” Can the management of the company operate a viable ongoing concern that can keep its competitive advantage, service the customer needs, retain its employees and maintain the critical operations required to be successful in the long run? Discount rates for second stage financings typically range between 30 percent – 50 percent.1
Final Words of Advice
The idiom “cash is king” has rarely carried more weight than it has over the past year. There are a plethora of bargains out there if you’re the king. With cash being so valuable, the competition vying for their share of the green is tougher than ever. So how is a startup going to get a piece of the action?
The onus is on the entrepreneur to focus on the validity of the idea, the timing of the raise and the required amount of capital. Presentations that lack credibility or seem to require excess capital will be rejected immediately.
A Side Note
The other night, I happened to catch Flash of Genius, a movie based on the life of Robert Kearns, the professor-turned-inventor who masterminded the intermittent windshield wiper. I squirmed in my chair as his invention was blatantly stolen from him. Although his story had a somewhat satisfying ending, the point that stayed with me was that from the very beginning, he did not have the proper support structure to safeguard his interests. Understanding how to maximize ownership of your ideas throughout the process of raising capital will ensure that as your invention gains traction and your company grows, so will your bank account.
Consider This
Think about what investors want. Lower their risk and raise their returns. Create a checklist that includes the most important capital-raise criteria. Include the following:
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- Large total available market
- High barriers to entry
- Growing market
- Razor vs. razor blade (i.e. annuity component)
- Exceptional documentation and testing controls
- Substantial proof of efficacy
- Well defined milestones
- Tranched capital raises
- Credible business plan
- Sahlman, William A., A Method for Valuing High-Risk, Long-Term Investments, Harvard Business School, Aug. 12, 2003
Scott Waxler is Managing Partner of LockeBridge, LLC, an investment banking firm in Lexington, Mass., that specializes in mergers and acquisitions, divestitures, capital raises and business advisory services. www.lockebridge.com
