Financing Your Debt:  Early Stage Venture Debt

Venture Debt is a rather complex topic, so I need to break this down into two different parts.  This is the first of those parts and has to do with Valuation.  Now, as I have said the actual valuation of a startup is a problem.  There is little to no revenue and there will be ongoing losses for some time.  Uniqueness and IP Value are in the eye of the beholder, so one way out is a form of Venture Debt.  The point of this post is actually to help you get a handle on some other terms, so our financial example is going to be pretty simple.

Now let us imagine a company where you have been able to pull together a modest amount of Friends and Family money.  You are on your way, but struggle to raise Angel money because their is a disconnect on valuation.  If you don’t get some money pretty quick, you will need to stop or nearly stop the company.  This loss of momentum is bad and most times is unrecoverable.

Now if the company was more advanced you would go to a Venture Capitalist (VC) or 12 and raise what is called a Series A Round (aka an A Round).  The problem is that the company may not be mature enough for this to happen.  In today’s world, a software application needs to have a somewhat functional prototype to get this money.  It is different in hardware or bio technology, but all of them have some points to get started.

So, is there a solution to bridge this situation?  Well, yes there is.  It is a strange form of Convertible Debt with step-up preferences.  The notion here is that a lender provides some cash (in this case let us say this is $250,000).  There are two points going forward:  the company either gets to an A Round or it does not.  If the company does, then the Debt can be converted to equity or paid off in the A round with a Step Up.  This is a percentage that the loan gets as a fixed “interest” payment.  It works something like this.  Let us say you gave the lender a 10% Step Up.  That means that the investment is counted as $275,000 instead of $250,000 when the A round gets completed.  Remember the Creditor here is taking on significant risk.  The company may not reach an A Round, at which point all the money is lost.  So, you can expect these to have a significantly higher value to the Lender than a Bank Loan.

This Loan will also have a preference to it.  That means that it gets dealt with first over everybody else.  They provided funding when nobody else would so that is fair.  The other good news for the Lender is that he/she has a relatively early liquidity event.  They can get paid off if the company is successful in raising an A Round or they can get an extra bump to the money that they put in.  And this is true regardless of the Valuation of the company in the A Round.  Thus, they get significant risk reduction for providing very early stage capital.

Have a great day!

Jim Sackman

Focal Point Business Coaching
Business Coaching, Leadership Training, Sales Training, Strategic Planning

Change Your Business – Change Your Life!

Sonoma County: News and Notes

Well, next week will start the Earnings season as Q2 results come out.  As you readers know, I publish Earnings Analyses of Enphase, Autodesk, Calix and Keysight.  If there are other public companies that are of interest in the North Bay, please let me know.  I have significant experience in the quarterly call language, the public market language and mergers and acquisitions.  I try to make my review of the numbers and the dialogue make sense to the lay person.

Real Estate continues to be a big story here in Sonoma County.  A number of properties that were in the rental space are being taken off the market and sold.  These were typically property owners who did not really want to be landlords but could not afford to sell these homes until recently.  This small inventory has not shifted the pricing down, but has helped put some inventory into the market.  The Commercial Real Estate world is tight as well.  The Cannabis market is causing significant amount of warehouse and similar space to be moved to becom grow houses.  This has caused some significant dislocation for local businesses.  I personally know of 3 automotive repair and service businesses that have had to relocate or go out of business because of this shift.  I have heard some rather challenging pricing for this kind of space at the moment.

It has been all quiet on the water front this year given all the rain we had.  The grape harvest forecast is in the “normal” range at the moment and is likely to hit its stride a couple of weeks later than last year.  Call it sometime in early to mid-September.  Somewhat lower yields are expected to be offset by higher quality, but there can still be slips twixt cup and lip.

This weekend is the Santa Rosa Ironman event.  There are significant Road Closures to support the event.  Take a look at the Press Democrat Website for details on that.  Also the Sonoma County Fair starts August 3rd, so remember that there will be increased traffic around the Fairgrounds.

Have a great day!

Jim Sackman
Focal Point Business Coaching
Business Coaching, Leadership Training, Sales Training, Strategic Planning

Change Your Business – Change Your Life!

Financing Your Business: Valuation

I have dabbled in this topic a bit.  But we need to talk about Business Valuation when we talk about Equity.  That is the key to understanding Equity Investments and Equity Investors.

There are 4 basic types of Investors in the Public Market:

1 – Value Investors:  These people look at the numbers associated with the Operational Part of the Business as well as other Financial Metrics.
2 – Growth Investors:  These people look at the Market and Market position of the company to evaluate the potential for future growth.
3 – Technical Investor:  These people study metrics around the stock price and recent price trends to look for positive and negative signs in the price of stock.
4 – Day Trader:  These people look to trade regularly for small variations in the stock price to be able to extract value.

These last two will not be part of our conversation today.  They require the public market and its open nature to work.  You can’t use these techniques to invest in private companies.

Everyone else is a combination of the other two.  Private Market transactions will have a significant weight on Financial Metrics of the company, especially for established businesses.  Startup businesses will depend more on the Growth that is envisioned and thus the future of improved Valuation to be able to establish a price.

For an established business, most of the time it will be pretty simple.  There is a multiple of cash flow and an addition for excess capital on the balance sheet.  The cash flow multiple is specific to certain industries and there will often be comparable transactions that can be used to set the multiple.  The biggest single issue is the state of the financials in most small companies.  Small businesses are captured financially to maximize the tax benefits to the owners.  In general, that means that the company is actually making more money than is stated by the P&L.  There are expenses that the company takes that are benefit to both the business and the business owner outside the business.  In a large, public company these expenses are not allowed, but often pollute the value of smaller companies.  What is required is that what is handed to investors are Generally Accepted Accounting Practice (GAAP) financials.  In the case of a private company transaction, there may need to be a reconciliation of the normal books to GAAP Books to ensure that things are clear.

This is also true for the Balance Sheet.  I often look at Internet Service Providers in my Consulting Business.  These companies tend to have extensive Capital Investment where a normal business may own its building.  These investments are great on the Balance Sheet and are depreciated over the life cycle of the asset.  Here too there are tax accounting considerations.  Small Capital Investments are often expensed as Cost of Goods Sold (COGS) and not depreciated.  This accelerates their tax benefit, by lowering earnings.  But since we are looking at a multiple of Cash Flow, this needs to be dealt with properly.

There can be additional issues with expenses, particularly the use of cash versus accrued accounting.  In most smaller business, this will tend to have a smaller impact but can be important.  As can the amortization of expenses over the year.  The important part of both styles is that expenses are taken in the same year that they are used and that they are smoothed so that Cash Flow is as consistent as possible over the year.

Now let’s take a look at the Growth side of the equation.  Here what we are really talking about is setting a floor for value or a higher than normal multiple of cash flow based on what business you are in.  Alternately, this can be also a strategic set of customers that the business has.  The challenge for most smaller businesses is that they are small.  Most strategies involve larger moves…things that move the financial needle.  So, here what you need to think about is what is so invaluable that a competitor would have to spend a lot of money to get at.  This is a lot less deterministic and thus there are a lot more disagreements on this front.  This is particularly true for Startup businesses.  So next week we will talk about a solution to this called Venture Debt.

Have a great day!

Jim Sackman
Focal Point Business Coaching
Business Coaching, Leadership Training, Sales Training, Strategic Planning

Change Your Business – Change Your Life!

Net Neutrality Thursday

I had a couple of people forward me these emails to speak out about Net Neutrality.  Since I do that and have done that, well here is another post on that topic.  I want to start with that everybody that comments on this has an agenda.  So do I.  My agenda is to try to change the primary issue to Universal Broadband Access and away from Net Neutrality.

I want to change this for 2 reasons:

– No Tier 1 has been shown to violate Net Neutrality (Comcast – Netflix was shown to be a problem with Cogent; a Netflix vendor)
– We still have a divide and no plan to provide escalting bandwidth and our existing methodologies have failed

This lack of broadband exists in some city neighborhoods and some rural areas but is generally not a problem in smaller cities and suburbs.  The problem I have with our current version of Net Neutrality is more technical and comes from two places as well.

First, I think we ought to redo our rules around residential service to make them common for all Service Providers independent of last mile technology.  The basic services are converging.  It seems silly to me to have multiple paradigms to regulate this under.  By having a common code, we have a more level playing field.

Second, I think we need to take a closer look at services and spectrum allocation.  Right now all of our broadband technologies support at least 2 and sometimes 3 services.  Many of these have multiple streams running in different bandwidth allocations over the same infrastructure.  For example, Cable Modems occupy 1 or more of the modulation groups on the cable.  The others are occupied by Linear TV and Pay-Per-View services that are not available for broadband.  The thing is that all of our networks would benefit from a retirement of older technologies and using a unified method of deploying services.  That way we can more flexibly allocate bandwidth and provide better service.

My proposal would be 100% penetration and conversion to IP delivery by 2025.  We could use the USF and other support mechanisms to make this happen.  This is the kind of infrastructure investment that we require for the 21st Century.  I would also add into this a requirement that all lines support 100 Mb/s symmetrical service at 2025 and that we have a plan to grow this over time with new numbers set in either 5 or 10 year increments.

This would spur massive investment in the US communications industry and make our network the envy of the world.  So if I were in charge, that is where my focus would be.  There is nothing wrong with making sure we have common carriage for most services.  But we need investment, and this is where it should go.

Have a great day!
Jim Sackman
Focal Point Business Coaching
Business Coaching, Leadership Training, Sales Training, Strategic Planning

Change Your Business – Change Your Life!

Financing Your Business: Venture Capital

Venture Capitalists are both very popular and very unpopular.  They get to be popular because they have money to invest and are looking to do so.  They are unpopular because they often ask for terms that the Owners do not like nor do they want to agree to.

But let us start at the beginning.  A Venture Capitalist (VC) generally works for a VC Firm that has one or more funds.  These funds are raised prior to their usage and have some notion of what kind of companies that will be invested in and when the investment will occur.  I want the reader to take two points from this.  First, a VC will not be a generalist.  They have restrictions on the kinds of firms that they can invest in.  This can be either by geography, stage of company, industry or any combination of all of these.  Second, there is a time frame in effect.  The fund investors expect to be able to get a return (or not) within a specific window of time.  It would be rare for anyone to have a fund that was open for a very long time.  The idea would be to complete the investment, return the proceeds to the investors and move on to the next.

There is also the notion of an Investment Committee.  This will be typical of larger, more professional organizations in investing.  In this case, a VC will bring the idea of the investment to the Investment Committee, who will ask a number of questions and approve, change or dissaprove the deal.  In general, the individual VC will not make a decision.

I expect to cover Valuation as a topic next week, but as I have said that is an issue.  Generally, the VC is going to want the Owner to lose control of his firm to the new investors.  They want to have a level of control over what they consider (in most cases) a less educated and experienced professional.  But you can also expect these new investors to want to have a number of Board of Directors seats and to be compensated for being on the Board.  Management can expect to report out regularly (often monthly) to the Board with metrics that show the company progress against the plan.  These can often be problematic as most Entrepreneurs are inherently optimistic.  Thus most plans fall behind and increasing pressure is asserted to meet the original deadline.

But the reality is that Venture Capitalists are all about the Exit or the Liquidity Event.  This is when the company makes the shares that the VC holds turn into cash in some form.  This is generally through a buy-out by a bigger firm or the company entering the Public Markets through an Initial Public Offering.  This Liquidity Event is supposed to put profits from the investment back into the Venture Fund, so that when the Fund expires that the original investors make a profit.  Along the way, the VC takes a percentage of the fund to run the VC firm and pay the employees.

Well that is the basics of the Venture Capital World.  Next time, we talk about Valuation.  Have a great day!
Jim Sackman
Focal Point Business Coaching
Business Coaching, Leadership Training, Sales Training, Strategic Planning

Change Your Business – Change Your Life!

Net Neutrality Thursday

This Sunday Game of Thrones starts its 7th Season.  This has reminded me of the change in tone at the FCC.  The new administration has brought a new viewpoint to the Iron Throne as it survey’s the Communications Industry Landscape.  I want to talk about a couple of the challenges along this line and then be clear about what I think should happen.

DSL, Cable and Fiber in the general case can have multiple networks running over the same medium.  They do this by using different parts of the frequency spectrum to run different services.  DSL is the simplest case of this and the spectrum from 0 – 4KHz is used for voice.  The rest of the spectrum (and it varies based on the technology) is used for Broadband Data.  This is similar to having many radio stations sharing the air to deliver different music, news and talk.  How this spectrum is used is not part of the debate.  What we will talk about is the usage of the Broadband Data part of the spectrum.  You can see immediately there are gaps in what we are going to discuss, for good or ill.

The question that really drove the Net Neutrality debate is this part about “Fast Lanes” or in Communications parlance – parts of the traffic with a Higher Quality of Service.  This is very standard throughout many networks today regardless of the technology used.  Within that Broadband Data, our current rules have that function unavailable.  That was the entire debate over the last few years.  Smaller companies argued that they might be able to deliver competent services over the network if you were allowed to pay for better service.  Note, that video in Cable and in Fiber often runs outside the Broadband Data part of the spectrum and thus can have whatever Fast Lanes it likes.  That is why you don’t see buffering from Cable offerings.

The flip side of this is whether the very high performance video – 4K and 8K TV – will actually work at scale as deployed without a “Fast Lane”.  There is no obligation for ISPs to make this work.  It will cost them a lot of money to do so at large scale so it might take a long time to get there from here.  What would be the recourse then?  We can’t make them build new networks.  It is pretty clear that nobody is about to install a 3rd or 4th competitive network (or it already would have happened).  By the way, I believe that it will be too much work to create “Fast Lanes” for it to be worth it.  Nobody is paying more without a guarantee.  And meeting a guarantee is a lot more than where we are today.

In the long run, I think the bandwidth providers will fall further and further behind their ability to apply strict rules and make them stick.  The best thing we can do on this is NOTHING.  If predatory practices happen, then crack down on them with all speed. I am much more concerned about deploying better infrastructure more broadly.

So watch Game of Thrones whether it is on your OTT service like Sling TV or on your Cox Cable and have a great day!

Jim Sackman
Focal Point Business Coaching
Business Coaching, Leadership Training, Sales Training, Strategic Planning

Change Your Business – Change Your Life!

Financing Your Business: Angels

Just like anything else, Media attention gives a view to something that is simpler and more interesting than it is in real life.  In this case, I mean the program Shark Tank.  What we see are very cute face to face presentations and immediate answers from the investors.  If you think this will work in the real world, you are about to be in for a rude shock.  Remember, Shark Tank is a TV show.  It is Entertainment set up to get ratings.  For real investments to happen, a whole lot more information is required than is exchanged.

For most people, Angel Investors are the first group they might consider after Friends and Family.  In most cases, these are High Net Worth Accredited Investors.  In other words, they have lots of money.  The US Government is greatly concerned about scams and hustlers taking advantage of people so there is a minimum level of sophistication that is desired.  This means that you are not facing celebrities as on Shark Tank, but you are facing experienced investors who want details.  Just as in my last post, it will often turn out that Valuation will be the biggest issue.  I want to get to that in some more detail in a later post.  Today, I want to talk about the process of addressing Angels.

There are often groups of Angel investors who meet as a group to review possible investments, have live presentations, and question and answer with the principals of the company.  The presentation consists really of two parts.  The first part is a business review.  This is an outline of the business plan and the idea behind the company.  One very important part of this will be a biography of the principals involved.  Remember, the investors are going to be interested in both what the idea is as well as who will be executing it.  Investors will be greatly impressed if you have a background in the field you are investing in and management experience within it.  They will be more impressed if you can show a successful sale of a previous company.

The second part of the presentation will be the request for investment.  In most presentations, this will be pretty simple from the legal documents to come later.  But you need to have a specific request for money and tell the investors what it will be used for.  On top of that, the percentage of the company that is up for sale as well as the pre-money and post-money valuations involved.  If there are multiple owners, they will also need to know the capitalization structure or who owns what.

Decisions can take weeks or months and are not likely to be the full amount required.  For example, I know of a company that raised $5M from Angels and it required around 75 investors.  This is an average investment of about $65K per investor.  In general, you need to expect $100K or less from each investor.  They know that most new ventures fail so they are expecting a high risk/high reward situation.  So, they are not going to give anyone a large amount of their Net Worth.  It is a a great way to lose that money.

So, that is the starting point with Angels!
Jim Sackman
Focal Point Business Coaching
Business Coaching, Leadership Training, Sales Training, Strategic Planning

Change Your Business – Change Your Life!