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.
[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.