Category Archives: Financial Plan & Financings

There is No Such Thing as a Free Lunch

Hamburger and potato freeI have counseled a number of companies in need of early stage funding to consider Kickstarter or similar campaigns, in which individuals contribute money to a company in exchange for very little (e.g. a t-shirt or a hand-written postcard that says “thank you”).  To the extent a company creates an effective campaign, the money need not be repaid nor does the contributor receive equity in the company—it’s free money.  Except when it’s not.

Recently a clever entrepreneur that I know launched a company to develop, market and sell a new electronic consumer product.  The product (which I will not describe to protect the innocent) was a break-through device that I, and many others, were interested in obtaining.  The entrepreneur created Kickstarter campaign to pre-sell the product.  In exchange for each $100 contribution to the campaign, the company promised to ship one of the products when ready.  The entrepreneur estimated that the product would retail for around $100 (with costs of goods at $50).

The campaign was a smashing success, with over 2,000 initial products sold (raising in excess of $200,000).  The entrepreneur then raised some equity capital on the strength not only of the $200,000 “free” seed money raised through the Kickstarter campaign, but also based on the big demand for the product.  Money in hand, the entrepreneur went about creating the product and building the company.

As (always) happens, the product took longer to develop and was more complicated to build than first imagined.  By the time the first commercial version was ready, the cost of goods had ballooned to $200, with a target retail price close to $400.  With time and volume, the company expected the price to drop substantially–maybe not all the way down to the initial $50/$100 range, but hopefully under $100 for cost of goods and under $200 at retail.  Because of the extended development time and increased costs, the company was also out of money and needed to raise a new round.

When new prospective investors analyzed the company, they saw a big problem:  the company “owed” its first 2,000 production units to the initial funders on Kickstarter.  Not only did that represent a $400,000 expense on cost of goods, it also would take up several months of initial production and shipping (at an estimated cost of $250,000 between outside production costs and inside burn rate).  Thus, the first $650,000 of new investment would have to go to pay for the past:  paying the costs of the “free” money raised on Kickstarter!  Needless to say, the funding did not get done.

While this is an extreme example of what can happen, it is a good reminder of the saying “money must be fed”:  no matter how one raises funding for a company, that money expects something in return.  Entrepreneurs have to make sure that they can provide those returns if they want to build a successful company.

Paying for the Past

credit cardsMany companies asking for investment have incurred debt in advance of receiving angel or venture funding.  Standard business debt (e.g. equipment financing or short-term payables) typically is not an issue for investors.  However, when the debt is money borrowed in lieu of (or lacking access to) investment capital, and the lender expects to be repaid, this can create difficulty in obtaining new investment capital.

I have seen entrepreneurs fund the initial stages of their companies through credit cards, home equity loans (their own or a family member’s), unsecured loans based on personal credit, and funds borrowed short term from friends.  These entrepreneurs often need to pay back the debt as soon as the financing round closes.  I’ve also seen companies in its early stages “borrow” money from employees by paying them in IOUs rather than cash, accruing the amounts owed on the books with an expectation that these amounts will be paid once the financing is in place.  This can create a legally-binding contract for payment to these early employees.

As a general rule, new investors do not want to see cash go out the door to pay for the past.  Investors are already sensitive as to how much of the financing round will go to pay the costs of the fundraising (typically legal fees, which can run from $10,000 to $100,000 depending on the amount raised, complexity of the transaction, involvement of multiple law firms and identity of those firms).  The last thing they want is to see hundreds of thousands of dollars (or more) being used to pay down debt, accrued salaries and other obligations.  Depending on the level of debt, this alone can dissuade a new investor from participating.

Entrepreneurs need to be creative in the early stages of building a company, cobbling together whatever sources of funds they can to create the next Google, Facebook or Linked-In.  While cobbling, the entrepreneurs need to be aware that the promises they make to people in the early stages can impact their ability to raise subsequent necessary funds.

Regulate, Deregulate, Repeat

Crowdfunding RegulationWhen I was in law school, one of my professors explained two diametrically opposed methods of securities regulation.  One paradigm involves creating a fair marketplace by carefully proscribing the actions of all players in the marketplace, dictating precisely what information must be disclosed and when and where that information must be disclosed.  In theory, everyone ends up with the same information about a company, leveling the investment playing field.

Challenges to this paradigm include coming up with enough laws and regulations to capture all the ways that people use to obfuscate what is really happening in a business, closing the loopholes through which companies disseminate information to favored parties, and ensuring that information is properly disseminated so that everyone has equal access to information.  Since no regulatory scheme can anticipate every potential problem, the legislature and regulators end up layering on an ever-growing body of law and regulations dedicated to closing loopholes and solving problems created by the last set of laws and regulations.

The other paradigm is to simply put a sign at the door saying “buyer beware,” and allow the free market to operate to regulate securities trading.  Over time, the marketplace will develop methods of ensuring trades are fair, information is properly shared and companies are held to high standards of reporting and disclosure.  The market will reward honest executives who produce outstanding results for shareholders, and criminal penalties can remain in place for those who defraud investors.

Given the primacy of the regulatory paradigm in the United States, I have always assumed that the Securities and Exchange Commission and Congress would lead an inexorable charge toward more and complex regulations.  Over my twenty-five years in practice, my assumption has held true (witness, e.g., Dodd Frank).  Which Congressman would ever want to sponsor the “Joe Smith Bill for Less Transparency and Accountability in Securities Trading”?!

Thus, I have been very surprised about the efforts of Congress to open the aperture on “Crowdfunding,” liberalizing both who can be solicited for investment and who can ultimately invest in private companies.  From allowing general solicitation (e.g., advertising to the general public as opposed to prior rules limiting solicitation only to so-called “accredited investors”) to (eventually) allowing non-accredited investors to invest in private placements without delivery of full disclosure documents, the new laws in theory can aid in capital formation for private companies, encouraging business activity and, hopefully, job growth.

I’m a big fan of anything that encourages capital formation, and I believe we do need to find creative ways to support entrepreneurs and early stage companies that don’t have access to the deep pockets of Wall Street.  That said, investing in early stage companies is inherently risky, with many (most) investors suffering significant losses.  Even for investors who invest early in a successful company, often during the 5 to 10 years it takes for a company to mature, that company will raise additional rounds of financing that, at best, will significantly dilute the early investors.  At worst, those rounds can squeeze out the early investors, leaving them with only good feelings about having seeded a great new company (how altruistic of them!).

I suspect that we will see both success and failure come from this experimentation in deregulation (not a very bold prediction).  The inevitable disappointments and failures will lead for a call to tighten a few rules, close a few loopholes and increase the regulatory oversight to prevent the problems from recurring.  My (slightly bolder) prediction is that, over time, we will end up approximately where we were when Congress first tried liberalizing the rules!

Growing Grapes

Red Grapes on the Vine in Napa ValleyDuring a winery tour in Napa Valley, our guide revealed to the group one of the secrets of growing perfect grapes for wine: restricting the amount of water fed to the vines. She explained that, with a restricted water supply, the vines concentrated their growing energy on the grapes in order to enable propagation of the species. With all that energy going toward the grapes, the grapes would be filled with rich sugars for later fermenting.

If they over-watered the vines, the vines would start growing lush leaves, which would provide a beautiful canopy while it competed with the grapes for available resources, diminishing the quality of the grapes. And watch out if water becomes scarce: the vines will suck those grapes dry in order to continue feeding the pretty leaves. Eventually, all that will be left will be the vines, some leaves and a bunch of shriveled raisins.

To me, this is a great analogy on financing companies. If you keep the money supply tight, the company focuses its energy on the things most important to keeping the company moving forward. If you over-water that company, it starts to build a lot of leaves: corporate functions and capacity that are “nice to have” luxuries at best and premature waste at worst. Moreover, when an over-built company runs short on funds, the amount to keep the company going may be too much to justify based on its larger-than-necessary burn rate, plus the cost to downsize the company (severance) may be more than the investors are willing to bear.

Every time we invest we risk turning a good project pre-venture financing into a failure brought about by infusion of the very capital we think the company needs to grow. We strive to find the balance between investing too little (thus retarding growth) vs. too much. By remembering that we want to grow grapes, not leaves, we can get that balance right.